Inflation collides with growth fears to cause large volatility in the bond market

A battle erupted in the bond markets, pitting investors’ fears of inflation versus their concerns about slowing growth. The result is increased volatility and a cloudy outlook for other investments.

Recent data showing expansion and acceleration of inflation drove up Treasury yields last week, but the rally masked huge volatility. In just a 15-hour period on Thursday, the benchmark 10-year US Treasury yield started at around 3.2%, rose to nearly 3.5% and then fell to 3.18%, making gains and losses at a different time. Each can take weeks. Yields rise when bond prices fall.

Among the defining factors driving these daily moves are the sudden increase in interest rates by the Swiss National Bank and sharp declines in US stocks. On a larger scale, though, bonds are simultaneously under inflationary pressures and bolstered by the rising prospects of a near-term recession.

Treasury yields, which largely reflect expectations for short-term interest rates set by the Federal Reserve, had one of the fastest hikes in history this year as stubborn inflation prompted the Fed to dramatically increase its expectations of how interest rates could rise. .

Central bank officials have made higher yields an explicit policy objective. Higher returns translate into higher borrowing costs for businesses and consumers, which will eventually lead to less borrowing, less spending and a slower rise in consumer prices.

Thus, the process of controlling inflation led to the worst bond yields in records going back to the 1970s. But any signs of success should boost the asset class, even if the economy is shrinking and investors flee riskier assets.

If interest rate expectations are stable, investors can take advantage of the new higher yielding Treasurys without worrying about further price drops. Moreover, bonds should rise if slowing growth and inflation cause the Federal Reserve to cut interest rates — or not raise them as high as currently expected.

The problem investors are now facing is that the economy is sending such mixed signals that data shows one day hot inflation, and a few days later evidence of sluggish housing demand and a sharp drop in consumer and business sentiment.

As a result of these cross-currents, “there are no obvious ways to invest over three months in bonds at the moment,” said Jim Vogel, interest rate strategist at FHN Financial.

The impact of the stock slipping into a bear market has further complicated matters for bond traders.

Falling stocks can cause investors to flee to Treasurys, which can incur short-term losses but still offer essentially guaranteed returns if held to maturity. They can also slow the economy by draining investors’ wealth and increasing the cost of raising funds for companies.

The US economy has been sending mixed signals, with sharp inflation and evidence of a sharp decline in consumer confidence.


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One hopeful scenario for bond investors is that lower stock prices could help tighten financial conditions, causing the Fed not to have to raise interest rates as much as would otherwise be necessary.

But this dynamic can be difficult to maintain, because expectations of lower interest rates and bond yields have, in recent months, sometimes led to a rebound in stocks.

The volatility in the bond market continued until the end of last week. The 10-year yield started Friday’s US trading session at around 3.22%, hitting 3.31% by mid-morning and settling at 3.238%, according to Tradeweb.And the

Up from 3.156% in the previous week.

Notably, returns did not end the week much higher than they were the previous Friday, despite the sudden turnaround from the Federal Reserve, which delivered a 0.75 percentage point increase on Wednesday instead of the 0.5 percentage point investors had expected even just two days ago.

In fact, Treasuries rose on Wednesday after Federal Reserve Chairman Jerome Powell indicated that the central bank was not necessarily committed to any further rate increases of 0.75 percentage point. Falling stocks and weaker-than-expected data on retail sales, housing starts and industrial production contributed to the gloom on Wall Street, providing an additional boost to Treasurys.

The recent rise in yields has led to a turnaround among some economists who have long argued that investors were underestimating what was needed to cool an economy fueled by cash-fed consumers and a tight labor market.

Previous: As markets respond to higher interest rates and the risk of a recession, stocks are dropping near bear market territory. Gunjan Banerji of the Wall Street Journal explains what it takes to get stocks back into a bull market and why it’s hard to predict when they will turn around. Illustration: Jacob Reynolds

Last year, when markets were pricing the so-called Fed’s final funds rate at around 1.5%, former New York Fed President William Dudley warned that the Fed would likely need to raise the benchmark interest rate to at least twice that level.

However, early last week, the market rate for the fed funds rate was as high as 4%, and in an event sponsored by the Wall Street Journal, Mr. Dudley said the market was now “nowhere near what is true.”

Many investors share this view.

Roger Aliaga Diaz, chief economist, Americas at Vanguard and director of the company’s investment strategy group, said the 10-year Treasury yield has finally reached nearly fair value.

He said it was based on estimates that short-term interest rates should eventually stabilize at around 2.5% and that another 0.5 percentage point to 1 percentage point was needed to compensate investors for the risk of holding long-term Treasuries.

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However, some warn that there is likely to be more pain ahead for bonds.

When the Fed has tried to cool the economy in the past, it has consistently seen the need to raise short-term interest rates above the current level of inflation, said Zack Griffiths, chief macroeconomic analyst at Wells Fargo..

Assuming the Fed’s preferred measure of inflation could fall to an average of 3% next year, this suggests that the central bank would still need to raise rates to 4.5% to get it “physically in positive territory” on a basis. Inflation rate. This caused bond yields to rise even more.

Write to Sam Goldfarb at sam.goldfarb@wsj.com

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