Bond buyers have seen a turbulent quarter, with its recent vacillations leaving market participants unsure about the outlook for U.S. government paper.
A month ago, the bond market was on the cusp of disaster, as prices for short- and long-dated maturities tanked, sending yields, which move in the opposite direction, soaring amid the fear of re-emergent inflation.
As a result, the 10-year Treasury note yield TMUBMUSD10Y, +0.00% surged to a four-year intraday high of 2.95% in February, blowing past Wall Street’s quarterly forecasts and forcing analysts to raise their year-end targets. Rising inflation can chip away at bond’s fixed payments.
When those yield-boosting fears subsided somewhat, they were replaced by heightened concerns about President Donald Trump’s protectionist policies, which sparked a wave of stock-market volatility, drawing a flight to assets perceived as havens like bonds, which helped drive yields lower in March. The 10-year yield traded down to 2.741% and the 30-year yield slipped to 2.975% from a more than a two year high of 3.22% to close out the week, month and quarter.
Those gyrations highlight what has amounted to an unsteady period of fixed-income trading, which offered fodder for both bond bulls and bears.
Overall, however, the trend for yields has been higher as investors have bet on the possibility that inflationary pressures, along with fiscal stimulus measures from the Trump administration, would send yields up as the Federal Reserve might be forced to take a more aggressive approach on monetary policy.
During the first three months of 2018, the 2-year note yield TMUBMUSD02Y, +0.00% climbed 38.3 basis points in the first quarter, the 10-year note yield TMUBMUSD10Y, +0.00% rose 33.2 basis points, and the 30-year bond yield TMUBMUSD30Y, +0.00% rose 23.2 basis points.
The so-called twin deficits of tax cuts signed into law late last year by Trump and a two-year budget deal, which combined are expected to deepen the budget deficit and the current-account deficit, also has weighed on bond markets because it will translate in to the government issuing a glut of new paper to fund its plans.
Read: Here’s what ‘twin deficits’ means for the dollar and the Fed
Moreover, a cocktail of Fed tightening and diminished expectations for economic growth has created an unsettling dynamic in the shape of the yield curve, which describes the differential between short-dated note and longer-dated debt yields, which should naturally steepen because investors tend to demand higher coupons for lending money over a longer time.
Although the pace of fourth-quarter economic growth in 2017 was boosted to 2.9% from 2.5%, reflecting the biggest increase in consumer spending in three years and higher investment in business inventories, estimated first-quarter growth has slumped to 1.8% last week, from 4.0% in early February. That is according to the Atlanta Fed GDP Now forecast, which offers a real-time pulse on economic conditions.
As a result, rates for shorter maturities have been on the rise as the Fed hasn’t appeared to substantially waver from its plan to lift interest rates at least twice more in 2018, after hiking rates on March 21 for the fifth time since December 2015. The central bank’s economic projections in March showed interest rates tipping into tightening territory as stimulus-driven growth waned in 2020. An expectation of higher future yields can undercut appetite for outstanding Treasurys.
Meanwhile, growing concerns about the economic outlook for the possibility of policy missteps by the Fed has anchored longer-dated yields.
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The outlook for hawkish monetary policy in the next few years has helped keep the policy-sensitive 2-year Treasury yield near a crisis-era high, while nudging down the 10-year and 30-year Treasury yield.
“The Fed is still on track to move forward with further rate hikes, although the market is unwilling to price in more than two additional moves—at least for the time being,” said Ian Lyngen and Aaron Kohli, fixed-income strategists at BMO Capital Markets.
The overall effect has been a flattening of the yield curve. A flattening curve could imply bond investors are lowering their growth expectations. The spread between the 2-year yield and the 10-year yield has fallen to around 48 basis points—the tightest levels since 2007, see chart below.
“The rapid flattening of the U.S. yield curve has been telling us for some time that all might not be well with the U.S. economic recovery,” said Albert Edwards, global markets strategist for Société Générale.
Wall Street watches the shape of the yield curve because a flattening that results in an inversion of the curve has coincided with the past 7 U.S. recessions. Indeed, the New York and Cleveland Federal Reserve banks use it to calculate the probability of recession, sometimes defined as two consecutive quarters of economic contraction.
Read: Why stock-market investors should embrace a flattening yield curve—for now
The collapse of long-dated rates has also been driven by recent talk of a trade war. After President Donald Trump escalated his protectionist rhetoric, backing his words with tariffs on steel and aluminum imports, stocks fell sharply, driving investors to the perceived safety of government paper.
Besides the haven bids, Trump’s pushback on an era of free trade has dampened Wall Street’s enthusiasm for White House economic policy, which have been seen as investor-friendly up to now, said Charlie Ripley, investment strategist at Allianz Investment Management, in an interview with MarketWatch. This could stall the U.S. and the world’s economic momentum.
Shrinking growth prospects have led more investors to cut their expectations for higher inflation. The 5-year break-even yield, or the markets’ assessment of consumer prices over the next five years, has edged lower to 1.94% on Tuesday, from around a five-year high of 2.10% notched in February.
Read: ‘Benign inflation’ should stave off a bear market in bonds, says IIF
“Unless you see inflation pick up in a meaningful way, it’s hard for me to envision rates breaking out. People were extrapolating in January, and they were lazy around the math,” said Gregory Peters, senior portfolio manager for PGIM Fixed Income.
Peters is referring to an higher-than-expected wage reading in the January jobs report that pushed both prices for both equities and bonds into free fall, an unusual phenomenon, given bonds’ inverse relationship with risk assets.
This time-tested relationship reasserted itself after a few days, leading a few fixed-income strategists to forecast the 10-year yield won’t break above 3.00% in 2018—a yield threshold that some believe would heighten competition for buyers of stocks.
Whenever Treasurys have come under pressure, higher rates have threatened equity valuations pushing investors out of stocks into bonds, undoing the earlier selloff.
But even as the bond bull case has become more credible, many investors still see yields rising for the rest of this year, just not at the heady pace seen in the past few months.
“The Fed will tighten policy by more than investors are anticipating over the next year or so, as inflation picks up steam in response to a tight labor market and the prior weakness of the dollar. With this in mind, we continue to forecast that the 10-year Treasury yield will end this year higher than it is now,” said Oliver Jones, markets economist at Capital Economics.