Wall Street money managers looking to pile back into Treasuries after months of losses will have to contend with a Federal Reserve that stands ready to raise the stakes every step of the way.
An ever-hawkish Jerome Powell made that crystal clear Wednesday -- with a fresh warning that rates may yet peak at a higher-than-expected level thanks to raging inflation.
After briefly rallying on hopes that the world’s most powerful central bank will soon pivot to a slower pace of policy tightening, bonds duly resumed their familiar selloff mode across the curve and traders ramped up terminal-rate expectations once more.
The losses in Treasuries were led by the short-end on Thursday. The two-year yield rose as much as 11 basis points to 4.73%, a new high for this hiking cycle. In Europe, the yield on German 10-year notes jumped as much as 14 basis points to 2.28%. A gauge of dollar strength rose to a two-week high as traders entered short positions in the euro and the pound.
While odds suggest that Treasury investors will find life easier in 2023 after back-to-back years of losses, it may not be smooth sailing. Powell has just put financiers on notice after stressing there is “some ways” to go before monetary policy is sufficiently tight -- even after delivering another super-sized rate hike this week.
That, among other things, suggests investors may be disappointed if they expect higher bond coupons to far outweigh any price losses next year.
“They are still looking at as high a terminal rate as they need to deal with inflation,” Diane Swonk, chief economist at KPMG, said on Bloomberg Television. “They will keep going until they see a significant deceleration” in inflation “and they will hold rates high for a longer period.”
The Bloomberg US Treasury index is already down over 16% since the end of 2020 -- set for consecutive annual losses for the first time in decades. Money-market traders now see the effective Fed funds rate hitting a peak just below 5.2% in May and being not far below then by the end of 2023. Yet the outlook ahead is far from clear with Powell stressing Wednesday that the risks of the Fed reversing course too soon are likely greater than it possibly over-tightening at the cost of economic growth.
One silver lining now for bond holders is that the fast pace of tightening this year has boosted regular income payments they receive, helping buffer the hit from price-induced losses. The fixed semi-annual coupons on Treasuries are now as high as around 4% on some maturities. Bloomberg Intelligence says yields would have to rise a lot more than they did earlier this year before they would trigger a total return loss. Meanwhile a Bank of America Corp. analysis of 250 years of bond market data suggests that returns will be positive in 2023, if history is any guide.
“Next year will be a little bit better, but we aren’t loading up yet,” said Peter Sleep, senior money manager at Seven Investment Management. “Losses in some bond indices have been dire. Will we be making back all of that? No. Might things stabilize a little bit? Yeah. But if the Fed were to pivot too early we could be in for a whole new cycle of tightening if inflation proves to stay too high. That’s the biggest risk.”
The 10-year Treasury yield rose 10 basis points to about 4.1% Wednesday. This year the benchmark rate is up around 2.6 percentage points, after rising about 0.60 percentage points in 2021. It is forecast to decline to 3.44% by the end 2023, according to the median of 46 strategists and economists surveyed by Bloomberg.
What could fuel a bigger slide in long-term yields is if the US succumbs to a full-blown recession, as suggested by a slew of bond-market indicators. Most slices of the curve are now inverted -- meaning short term rates are higher than longer term. Meanwhile US manufacturing neared stagnation in October as orders contracted for the fourth time in five months, while an index of prices paid fell to a more than two-year low.
“Our base case is a modest recession in 2023 but there is also a possibility of a deeper recession given a risk of the Fed overdoing the tightening,” said Mark Lindbloom, portfolio manager at Western Asset Management.
Under those scenarios, Lindbloom said Western is seeking a balance between owning high-quality corporate bonds that can deliver returns of at least 6.5% next year along with long-dated Treasuries acting as insurance against weaker growth.
“As growth slows and inflation eases, bonds will do better in risk-adjusted terms to other asset classes,” Lindbloom said.
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