Bond markets starting to react to a new phase in the market cycle

Key takeaways
It has been quite a start to the year in bond markets. In fact, for US Treasuries it was the second worst start to the year since 1982, with 10 year yields rising by 0.25% last week1. Yields in UK gilts and other European core markets also rose.
So why did this sudden move in markets take place?
A number of bond-bearish factors combined last week to create this very sharp move.
At the start of that week, risk-on sentiment was buoyed by better Omicron-related data emanating from South Africa and London.
But the big new information came last Wednesday, with the release of December’s FOMC meeting minutes. These gave a clear indication not only that the committee has become more hawkish on rates, but also that quantitative tightening (the reduction of the Fed’s balance sheet) was likely to happen quite soon after interest rates begin to rise.
This would be a far cry from the path followed in the last tightening cycle when the Fed waited nearly two years before beginning to reduce the size of its balance sheet.
Sharp sell-off
By the end the week, the extent of the sell-off meant that technical levels came into play. The 10 year US Treasury breached the recent high of 1.70%, but more importantly, went through the post Covid closing high and intraday high, peaking at 1.7992%. This week, its yield surpassed 1.80%.
Fed Funds futures are now pricing in a greater than 80% chance of a hike in March and a total of three 0.25% hikes this year. For context, a 0% chance was priced in as recently as October.
As a result, investment banks are adjusting upward their US rate hiking expectations, with some calling for four hikes this year.
Whilst the move was very sharp and has continued into this week, the direction of travel is justified and understandable, in our view.
Why do we hold that view?
US CPI inflation is 7.0% and producer prices are rising even faster. These very high rates are likely to moderate as base effects start to influence the numbers but it is unlikely that inflation falls back to 2% any time soon. High inflation is at least in part a function of an 18 month period of particularly strong credit growth.
Invesco’s former Group Chief Economist, John Greenwood, has pointed out that US inflation will be persistent not transitory, ‘At the start of the pandemic, between February 2020 and July 2020, M2 in the US grew by almost $3 trillion, or by 18.4% in the space of five months. Since July 2020 it has grown by a further $2.3 trillion, making a cumulative increase of $5.3 trillion or 34.4% in eighteen months. These numbers are far in excess of any conceivable financing need in the real economy or any permanent increase in the demand for money.’
Unlike in previous recent episodes, the huge growth in money has been created at a time when the banking system is fundamentally secure and no longer deleveraging. This increases the likelihood that bank lending spurs economic activity further.
In addition to the inflationary backdrop, US economy is also enjoying a period of steady and positive GDP growth. The labour market is also tightening. Today the unemployment rate stands at 3.9%, just a few tenths away from the pre-Covid lows of 3.5%. US wages are also rising.
Our January resolution is to maintain cautious outlook
The backdrop of inflationary pressures and a solid economy has looked increasingly at odds with stubbornly low interest rates and government bond yields.
Even acknowledging that the structural forces that have helped keep yields low post the Financial Crisis have not necessarily disappeared, it’s hard to argue against the powerful concoction of inflation and cyclical pressures now building.
We have been cautious towards duration, and indeed all bond markets, for some time. At the moment, we are content to keep overall interest rate risk levels low and see how markets evolve.
Even having breached their post Covid levels, US 10 year yields are still very low even in the context of the last 10 years and real yields are still deeply negative.
With the US and the UK central banks likely to be tightening this year, the tone of policy backdrop has been set. We are prepared for challenging markets.