Investor Exodus from US Government Bonds
Investors have been selling US government bonds as the market grapples with the expectation of higher interest rates in the foreseeable future.
Historic Treasury Sell-Off
The Treasury market’s nosedive, which commenced in early October, stands out as one of the most significant crashes in market history. Notably, the 10-year Treasury yield reached 5% last Friday, a level unseen since 2007.
Staying in Line with Economic Expectations
Despite the recent market turmoil, historical patterns suggest that current yields align well with medium-term economic prospects.
Christoph Schon, senior principal of applied research at market data and intelligence firm Qontigo, informed Insider that a 10-year yield ranging from 4.7% to 5.1% appears suitable concerning the present long-term inflation expectations, approximately 2.45%.
A Shift in Bond Market Dynamics
In the 1980s and 1990s, the 10-year Treasury yield typically exceeded inflation expectations by a factor of two, as represented by the 10-year breakeven inflation rate. During this period, investors could anticipate real returns matching the expected inflation rate.
However, the dynamics shifted during the dot-com bubble and the 2008 financial crisis. Treasury bonds turned into assets where investors could park their funds while the stock market experienced prolonged volatility.
“Stock and bond prices started to move in opposite directions, complementing each other depending on risk appetites,” Schon explained.
He further noted that recent surges in consumer prices due to the pandemic and Russia’s invasion of Ukraine have reintroduced correlation between stocks and bonds. Both asset classes have seen simultaneous declines as interest rates have risen sharply.
The Current Environment
Schon argues that the current climate resembles the period before the 2000s when Treasury bonds served as an attractive alternative to equities, not merely a safe haven during turbulent times. Historical data suggests that investors should seek yields ranging from 1.9 to 2.1 times inflation expectations. With the current 10-year breakeven rate at 2.45%, this implies a corresponding nominal yield between 4.7% and 5.1%.
The Future of Bond Yields
Historical data also provides insights into the future direction of key bond yields. Schon believes there is less than a 1% chance that the 10-year Treasury yield will surpass 5.5%, barring any significant upward revisions in inflation expectations.
Federal Reserve’s Stance
Federal Reserve Chairman Jerome Powell, in a recent address in New York, stated that policymakers will allow the bond market’s volatility to play out. Rising yields have contributed to tightening financial conditions. Presently, the CME FedWatch Tool indicates a 98% probability of no rate hike at the Fed’s November 1 meeting and a 24% chance of a 25 basis point hike in December.
Differing Views
Despite prevailing market sentiment, some strategists warn of the potential for further yield increases. Phillip Colmar, global strategist at MRB Partners, predicts that yields may breach 5.5% in 2024. Additionally, Adam Phillips, managing director of portfolio strategy at EP Wealth Advisors, suggests that a possible government shutdown in November could push yields higher.
Barclays’ Perspective
Barclays strategists pointed out that the 10-year yield remains below the anticipated terminal rate for the Federal Reserve’s ongoing tightening cycle. This deviates from typical trends observed at the end of tightening cycles.
“The [bond] rally faces significant obstacles,” the strategists emphasized in a Wednesday note. “Despite continuous data supporting a robust economy, consensus expectations foresee a substantial slowdown in the coming quarters. Consistent misses raise questions about the consensus’s confidence in monetary policy being excessively tight. We contend that policy remains scarcely tight, with potential risks skewed towards continued positive surprises.”
