Seven months ago, it looked briefly as though the four-decade bond bull might finally end.
In fact, it did end by at least once measure.
The Bloomberg Barclays US Long Treasury Total Return Index fell into a bear market in March. The drawdown was ~22%, the worst ever (figure below).
There was palpable consternation about the potential ramifications. The decades-long “duration infatuation” in rates was on the ropes, and given the duration embedded across assets, the implications of a prolonged, deep bond selloff were potentially serious.
And then, it stopped. The arrival of the Delta variant and the proliferation of the “peak growth” macro narrative conspired with fears of a Fed policy mistake following the June FOMC meeting to push 10-year US yields some 50bps lower from the 2021 highs, which have yet to be reclaimed. We’ve been in a kind of limbo since.
Following the September Fed meeting, yields began to rise anew (figure below). Inflation is running the hottest in three decades, but the persistence of COVID, a bevy of macro headwinds and a stalled fiscal agenda in Washington effectively served as a cap on yields.
Yields hit 1.60% for the first time since June on Friday following a disappointing jobs report. That might seem somewhat counterintuitive, but an above-consensus average hourly earnings print and further evidence that the labor market is being constrained by a lack of supply, gave the otherwise lackluster report an inflationary feel.
“While the jobs numbers will leave tapering intact, slower progress on the hiring front will reiterate the notion that the operative debate at this stage is when the first rate hike of the cycle will ultimately take place,” BMO’s Ian Lyngen and Ben Jeffery said. “It is this balance between a willingness to offset substantially higher inflation and not prematurely cut off the recovery that will serve as the essential challenge for the Fed, and central banks globally over the coming quarters.”
This is all complicated by the burgeoning energy crisis and the overhang of the pandemic. Surging crude prices clearly play into inflation expectations and could crimp consumption. And so on. The macro is always a kind of moving Venn diagram. Even more so now.
Sundry pundits have their individual opinions, but the collective is confused. As Deutsche Bank’s Aleksandar Kocic put it, inflation “has become the key decision variable [but] like everything else, current inflation numbers are at the point of maximum ambiguity.”
The figure on the left (below) shows 5Y5Y breakevens are between two regimes, Kocic wrote. The boundary between high inflation and low inflation is marked as 2.50%.
The curve exists in a similar state of indecision. “Rates market still hasn’t fully made up its mind regarding the direction of rates,” Kocic went on to say. Referencing the figure on the right (above), he noted that “if we use a typically cyclical 2s/30s (or 5s/10s) slope as an indicator of a position in a cycle, current value, around 140bps, is almost exactly equidistant from the boundaries of two cycles – 200bps below the end of easing at 340bps and 140bps above the end of the hiking lows near zero.”
The simple read-through is that the curve “is embracing neither cuts nor hikes fully, rather waiting for a signal to engage on either side,” Kocic said, calling the configuration in rates metastable. “It has fragile local stability,” he remarked.
It’s possible we’ll loiter around current levels in the absence of uncontrolled shocks. That said, Kocic cautioned that “given the amount of fiscal and monetary stimulus already in place, if we start moving away from the present configuration, those moves will be big — especially on the selloff side.”
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