The Bond Vigilantes Ride Again

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With inflation back at 1980s levels, it is only appropriate that the so-called bond vigilantes return. Ed Yardeni coined the term in the 1980s to describe the action of bond market investors to demand higher yields in reaction to monetary or fiscal policies. The Federal Reserve (Fed) and other central banks overstayed their welcome with ultra-accommodative policies and will need to tighten aggressively.

Fed Chair Powell noted in his press conference that the labor market was “very, very tight” and “tight to an unhealthy level.” The Fed’s dual mandate is employment and price stability, so the combination of inflation and robust employment is a green light for an aggressive tightening of monetary policy. Markets will be watching the monthly jobs report on Friday closely. The unemployment rate is expected to fall to 3.7% while wage gains accelerate to 5.5% year-over-year. Investors should expect the vigilantes to continue pressing yields while the employment market remains tight.

In theory, the economy should be able to handle a significant number of rate increases given the firm foundation of demand and job growth. In addition, the real, after-inflation Fed Funds rate is only slightly above the lowest it has ever been, even after the most recent rate hike. Meanwhile, the price shocks from the war in Ukraine provide a significant downside economic risk if the prices result in demand destruction.

Markets are now pricing in the Fed increasing rates by over 2.4 percentage points in the next year and a half. That’s equivalent to almost ten hikes of 25 basis points (0.25%)! As proof of how aggressive the markets think the Fed will be, the futures markets essentially price in 50 basis points hikes (0.50%) in May and June rather than the more customary 25 basis points.

As defined by two-year US Treasuries, short-term bonds saw yields rise before the first hike. The yields on short-term bonds have moved sharply higher already and are discounting aggressive rate hikes by the Fed. The 2-year rate is not far from pre-pandemic levels. If inflation begins to moderate and the Fed is not forced to hike more than expected, the short end of the curve has become more attractive. While these rates are still below the current inflation rate, it is finally above the Fed’s 2% long-term inflation target.

As defined by ten-year US Treasuries, longer-term bonds have seen yields move swiftly higher. Two variables likely primarily determine the fate of longer-term rates, inflation and the strength of the economy. Based on our historical nominal GDP growth and inflation model, odds favor higher yields on the 10-year unless demand destruction negatively impacts those variables.

Stocks continued to move higher last week despite the march higher in both short and long-term rates. Historically, equities have been able to navigate higher long-term yields successfully. Higher rates are typically a sign of economic growth, so the positive correlation makes sense. However, periods of higher yields and poor economic growth are not a good recipe for returns from stocks or bonds.

The bond vigilantes seem likely to continue to hold the Fed’s feet to the fire to act aggressively in tightening policy in the face of the inflation threat. The yields on short-term bonds have moved sharply higher and are discounting aggressive rate hikes by the Fed. Unless the price shocks show up in a weakening job market, odds should still favor higher yields and thus lower prices on 10-year Treasury bonds.

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Credit: www.forbes.com /

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