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Thursday, February 10, 2022

'The Lord of the Rings' wizard has nothing on yields that refuse to pass 2%

Bond yields have been on the march, testing their highest levels since before the onset of COVID-19, just as the Federal Reserve embarks on a rate hike campaign to tame inflation.

Yet with data Thursday morning expected to show the highest U.S. price pressures in nearly 4 decades, government rates still look awfully cheap (to say the least), considering we're in an environment categorized by relentless inflation.

Stubbornly low yields recall the searing image of Gandalf during that immortal "The Fellowship of the Ring" scene, with the defiant wizard trenchantly screaming "you shall not pass!" (in this case, the 2% level on the Treasury curve).

According to Tradeweb data, 2-year/10-year yield spread, a barometer of economic concerns, is now at its flattest since October 2020. It suggests that if investors are worried about the outlook, it’s not fully reflected in bond prices — especially with Wednesday’s 10-year auction characterized by strong enough demand that yanked yields back from 27-month peaks.

It's puzzling enough that Bloomberg executive editor Robert Burgess on Wednesday demanded to know if bond investors — particularly foreign ones — have gone "completely insane" by "clamoring for Treasuries." All of which begs the question: Why are bonds still seemingly in a bubble, with soaring inflation and a hawkish Fed?

The short answer is that a Fed poised to withdraw trillions of dollars in monetary stimulus is... well, still injecting trillions of stimulus into markets via quantitative easing (i.e. bond buying). It’s a situation that Pantera Capital CEO Dan Pantera told Yahoo Finance Live last month was “the biggest bubble out there,” and keeping yields capped.

In truth, it’s not just U.S. government debt. From Britain to the European Union, global central banks are also trying to play catch up on monetary tightening, Yahoo Finance’s Brian Cheung reported this week. In theory, the emerging inflationary status quo spells higher rates, and higher bond yields, even if they’re not quite there yet.

On Wednesday, Goldman Sachs did hike its forecasts for U.S. Treasury yields, given the economy’s ongoing expansion and the Fed’s hawkish pivot. The bank now sees benchmark 10-year Treasuries yielding 2.25% (up from the prior 2% estimate) this year, and 2023 at 2.45% (higher than the previous 2.3%).

Still, considering the state of things, those numbers should be much higher. Bond investors seem torn between an expansion that, while showing signs of wear, is still robust, and a tightening cycle that will clearly put upward pressure on rates.

What that means is yields are seen setting a base around 2%, but not much higher than that — and certainly well below current levels of inflation, which would be a giant red flag (bond vigilantes, anyone?).

Jay Hatfield, chief investment officer at ICAP, noted that there are at least three additional factors capping longer-term Treasury rates. These include a mind-boggling $52 trillion (several orders larger than the entire U.S. GDP) of global pension assets tied up in bonds; a yield curve that tends to flatten during a Fed tightening cycle, and sluggish growth expectations in Europe and China.

However, Deutsche Bank chief economist Jim Reid mulled whether the bond market “really knows best,” and whether the failure of borrowing costs to skyrocket suggests inflation really is transitory, as the Fed once argued before it retired the dreaded phrase in November.

Low yields “could be giving us a message” about a bond market that’s currently understating future inflation, Reid wrote this week. Still, “ if history is to be believed it will likely be random if bonds are correct rather than them being some great prescient force,” he said.

“I’ll contradict myself a little and say I’m still a firm believer in the power of the yield curve in predicting the cycle, just not the overall level of yields on future inflation.”

By Javier E. David, editor at Yahoo Finance. Follow him at @Teflongeek

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