Bond yields will keep falling. What is behind the puzzling movement.



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The betting odds are starting to smile on Lael Brainard as the next chairman of the Federal Reserve.

Zach Gibson / Bloomberg

There is a conundrum in the bond market. Bonds are rallying, pushing down yields, which move inversely to prices, despite strong indications that things should move in the opposite direction.

Let’s take a step back. The yield on the benchmark 10-year US Treasury bond surpassed 1.7% in October, reaching its highest levels since April, when the crossing of that threshold raised real concerns.

The blame game underscored, among other things, the prospect of the Federal Reserve ending its bond buying program and starting to raise interest rates, the debate over the duration of inflationary spikes and nerves on edge. about the American debt.

These macroeconomic concerns have not gone away, but yields have come down, as the 10-year Treasury yield fell further to 1.44% on Tuesday.

In fact, some of these concerns have been confirmed and even amplified.

The Fed announced this month that it will indeed begin to slow, or reduce, $ 120 billion in monthly asset purchases of $ 15 billion per month, with a goal of ending the program. pandemic era to add liquidity to the markets by next June. This paves the way for possible rate hikes in the second half of next year, even as Fed Chairman Jerome Powell hammered the cut does not mean tightening monetary policy, for the United States. instant.

Inflationary fears remain. In fact, as he announced the reduction plan, Powell explained how the central bank sees higher inflation persist, eroding part of the argument that inflationary spikes were only transitory.

“Tapering will likely be followed by tightening if inflation remains persistent, which seems more likely now,” Yardeni Research economist Edward Yardeni said in a report Tuesday, highlighting the bond conundrum. “Still, the bond market has chosen to focus on Powell’s most conciliatory statements.”

To add to the pile, US spending is still on a tear. Passage of the $ 1.2 trillion infrastructure bill by Congress last week – a hallmark of President Joe Biden’s economic agenda – is expected to add some $ 256 billion to the budget deficit over the next 10 years , increasing inflationary pressures.

Yardeni offered three possible reasons why bonds continued to recover.

The first is that the Fed and the banks are still buying bonds; the reduction means the pace will slow down, but the cash bowl is still filling up for now. Foreigners can also buy US bonds as an alternative to domestic bonds in countries like the UK and Germany.

But perhaps most interesting is that retail investors are buying bond funds, with cash from individual investors flowing into mutual funds and exchange-traded funds that hold bonds, according to Yardeni.

“The question is, why would retail investors find bonds attractive at historically low yields? Yardeni asked. “The answer could be that not everyone agrees that there is no alternative to stocks. In addition, as stock prices have skyrocketed, some investors may rebalance their portfolios in stocks and bonds. “

As bond yields remain depressed at the start of the week, another factor is at play: the future of the Fed.

Powell’s future as head of the central bank looks increasingly uncertain. The betting odds, according to PredictIt, are starting to be less favorable to Powell, with Fed Governor Lael Brainard becoming an underdog favorite.

“With each passing week, Joe Biden’s failure to re-appoint Powell reduces the chances that the Fed chairman will not see a second term,” Louis-Vincent Gave, CEO of Gavekal Research, wrote in a note Tuesday. “It may help explain the recent rallies in bonds and stocks. If Powell is to be replaced, his successor will likely be even more accommodating. “

Brainard, a Democrat, is a more accommodating person. But even if she succeeds Powell as Fed chairman, that doesn’t mean Brainard would keep rates low any longer, let inflation run wild and see bond yields continue to fall.

“The reality is actually more complex,” said Sebastian Galy, macro-strategist at Nordea Asset Management. “She will probably have to become more hawkish first before she changes course.”

Galy describes the fundamental problem facing Brainard, or any successor to Powell: how to keep inflation under control while maintaining a solid pace of economic growth. This may not keep returns low forever.

“It should take a few weeks for this point to materialize,” Galy said.

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