Bond markets prematurely second-guess the Fed’s rate hike stance

All eyes have been on rising US bond yields and, to a lesser extent, SA’s over the past week, as fears of inflation prompted investors to anticipate central banks withdrawing their support earlier than expected.

For SA and other emerging markets, the concern is that higher US bond yields could undermine risk-on investor appetite for emerging market assets, just as markets begin to believe 2021 will be a bumper year for developing countries, supported by robust global economic growth and low developed market yields.

For now, however, we are moving in the opposite direction. Since the start of the year, US 10-year Treasury yields have added 45 basis points to about 1.39%. But it’s a move that could well prove premature. Investors are anticipating a shift in monetary policy stance, though far ahead. An interest rate hike was expected in 2024, but now markets are factoring in a hike a year earlier in 2023 – still two years away.

So why the overreaction? The Bureau for Economic Research says higher yields have been driven by investors “being receptive to the idea” that US inflation will accelerate, driven by sustained gains in relative commodity prices.

“More fundamentally, the inflation anxiety reflects overheating concerns as increased mobility tied to the vaccine rollout and another massive US fiscal stimulus package are projected to converge in the second half of 2021, unlocking large US household savings and fuelling an expected robust rise in consumer spending.”

‘We will give lots of warning’

As a result, bond investors have begun to position themselves for the Federal Reserve having little choice but to start withdrawing the punch bowl earlier than expected. This despite the Fed insisting inflation won’t be a material problem for the foreseeable future.

Speaking to the Senate Banking Committee, Federal Reserve chair Jerome Powell this week again said he didn’t expect inflation to rise to “troubling levels” and gave his assurance that the Fed had no intention of repeating the inflation mistakes of the 1970s.

He attributed the rise in bond yields to investor confidence that more normal conditions were returning. But he stressed that, though many parts of the US economy have improved, unemployment remains an issue and that there is still a long way to go before the US economy will be back to normal. Until then, there will be accommodation: “We will move carefully, patiently, and we will give lots of warning.”

It remains to be seen how investors will respond, but nervous anticipation of a 2013like taper tantrum is unlikely to disappear as long as there are fears of economies overheating and inflation reappearing.

Blackrock has adjusted its positioning “on a tactical basis”, in anticipation of rising nominal US yields in response to a strengthening economy, a huge fiscal impulse and rising inflation.

It’s all still very liquid for now

Local government bond yields followed global bond yields higher and there could be more to come. With about 30% of our domestic bonds owned by foreigners, net disinvestments from our bond market would put further upward pressure on our yields.

Prescient Head of Bonds Reza Ismail sees US yields marching incrementally higher off a very low base level of 1.3% even though breakevens are at five-year highs. “Financial conditions globally are still very loose and accommodative, liquidity is plentiful, and developed market central banks will maintain these accommodative policy environments until there are actual, meaningful increases in consumption-based inflation prints,” he said.

Ismail believes accommodative policy, with global aggregate demand improving, will lead to significant support for selected emerging market destinations that offer high real yields and that SA yields still stand to compress meaningfully.

But the road ahead is still unclear. When do we reach the point at which the central banks decide they need to begin unwinding the very loose monetary policy that has prevailed since the 2008 financial crisis? And can they do so without setting in motion a series of financial market meltdowns?

For now, there is reason to believe that investors are worrying prematurely about central banks shifting away from their currently accommodative stance and, as the saying goes, “Worry is like a rocking chair: it gives you something to do but never gets you anywhere.”

This is an opinion piece by Sharon Wood, who is a freelance communicator.