Has the US bond market hit bottom?

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by Alexander Jonesinternational banker

aAccording to research by Edward Macquarie, professor emeritus at Santa Clara University, 2022 was the worst year on record for the US bond market since records began. With nearly 10 months of this year seeing bond values ​​fall even further, one might expect 2023 to be on track to surpass that record and decisively extend the worst bear market in history. While this may still happen, the broad reversal in bond yields since late October against a moderate outlook for the US economy suggests that the worst for the bond market may have already come and gone.

Indeed, this year has seen nothing short of a wholesale rout in the bond market, which bottomed out in October, as fears that the Fed would keep interest rates “higher for longer” sent Treasury yields to their highest levels. . Levels at 16 years. By October 23, the benchmark yield on 10-year US Treasury bonds was trading at just over 5% for the first time since July 2007. With long-term Treasury prices having collapsed by about 40% since the outbreak of the pandemic in early 2020. However, the losses accumulated during this crash were more than double those observed in 1981, when the 10-year bond yield rose to 16 percent.

US fiscal and monetary policies haven’t exactly helped matters, especially the government’s insistence on continuing liberal spending despite facing a massive $2 trillion budget deficit (which, when readjusted to take into account last year’s failed student loan forgiveness plan, It was a huge deficit. Double the deficit recorded in 2022, amounting to one trillion dollars). Financing this spending has required massive amounts of borrowing, with the Fed duly committed, leading to debt exceeding $7 trillion by November. The excess supply of Treasuries in the market caused the value of bonds to fall further, sending yields higher and ultimately creating massive bearish sentiment across bond and stock markets, as investors’ appetite for risk diminished amid a high-interest-rate environment that continued to borrow for businesses and households. . Expensive.

In fact, the three months through September saw yields rise a full 1% as speculation mounted that interest rates would remain high through 2024 to bring inflation down to the Fed’s 2% target. In August, the US Treasury announced that it would buy up to $1 trillion in bonds in the three months through October, which also fueled investors’ bearish sentiment on the mismatch between supply and demand. “The unsustainability of the fiscal framework is probably the biggest factor driving this bond fear,” said Jim Selensky, chief investment officer for fixed income at Janus Henderson Investors. Financial Times (FT) on November 6. “Supply is shifting upward at the same time that demand from price-insensitive buyers – most notably from central banks – dissipates.”

But as the US economic outlook has improved in recent weeks, there has been a decisive reversal in bond yields, with the 10-year Treasury yield falling from 5% during the last week of October to below 4.5% by mid-November. Among the most important supporting economic data was the annual inflation rate for October, which came in below expectations at 3.2%, which strengthened confidence that the inflation rate is now moving steadily towards the Federal Reserve’s target of near 2%. The 4.9% quarter-on-quarter growth rate in the third quarter also eased concerns somewhat, albeit with government deficit spending contributing significantly to the figure. Traders are therefore widely bracing for the end of the Fed’s interest rate hike cycle.

Does this mean that better days for bond investors are now here? Not necessarily, as officials continue to warn of pricing in an imminent interest rate cut, despite boosting expectations from October’s inflation number. “We need to be patient and assertive, and I wouldn’t take traditional steadfastness off the table… We need to look holistically at the data,” Boston Fed President Susan Collins told CNBC on November 17. While The Fed may have finished raising interest rates as part of this tightening cycle, and current levels of inflation reduction may be maintained further before the rally regime ends for a longer period,” explained Alberto Gallo, chief investment officer and co-founder of Andromeda Capital Management (ACM). , for “It is still too early to say that interest rates and inflation are completely clear.” Bloomberg. “The Fed may be done raising interest rates, but that doesn’t mean a lot of cuts are coming soon.”

Recent evidence also suggests that investors want additional compensation for purchasing longer-term government bonds. In fact, yields briefly rose toward 4.7 percent after a lackluster auction of 30-year Treasuries on November 9, which saw the Bloomberg Treasury Index post its worst daily performance in more than six months, further highlighting the market imbalance that has… It led to lower prices and lower returns. High yield. “What the auction outcome indicated is that everyone is worried about supply now,” said Mark Nash, head of fixed income alternatives at Jupiter Asset Management. Bloomberg. “Things are changing in the market in terms of support.”

Furthermore, when assessing the market over the long term, some believe that this current tranche of rising bond yields represents a “new normal” for financial markets, with higher interest rates and higher, less stable inflation rates. For example, the low inflation and ultra-low interest rates in the decade following the 2008 global financial crisis may end up becoming outliers, according to Brevan Howard, chief US economist at Brevan Howard Asset Management, Jason Cummins, with “research This environment forces investors to accept progressively lower premiums to hold longer-term debt. This capitulation has been exacerbated by massive bond purchases by the Fed and other central banks for quantitative easing (QE) programmes, which have put further downward pressure on yields, Cummins added.

“In the past, investors have expected the Fed to cut interest rates whenever threats to growth emerge. With inflation exceeding the target, central bankers are unable to mitigate shocks to the real economy or turmoil in financial markets,” he explained. “The era of the Fed’s ‘put-down’ is over,” Cummins wrote in a November 3 article for The New York Times. Financial Times. “The Fed not introducing interest rates means no zero interest rates, no promises of lower interest rates in the future, and certainly no quantitative easing to bail out investors when they suffer losses… Looking back, the new normal looks like a unique time.” From historically low interest rates after the financial crisis, in the future, investors will have to relearn how to operate without a financial or monetary safety net.

With long-term expectations that the federal budget deficit will continue to worsen, higher US bond yields may persist for some time. In fact, the Congressional Budget Office projects that the U.S. budget deficit over the next 30 years will easily exceed the average 3.7% of the country’s GDP recorded between 1993 and 2022, reaching 6.4% in 2033 and 10.0%. In 2053. Meanwhile, the International Monetary Fund said it expects the deficit to exceed 8 percent of GDP this year and net borrowing to remain high at 7 percent of GDP in five years.

Not surprisingly, Moody’s Investors Service announced on November 10 that it had lowered its credit rating outlook for the United States from stable to negative due to financial mismanagement. Although it remains the only agency among the “big three” credit rating agencies that has not downgraded the US sovereign rating yet (Fitch Ratings announced it lowered its credit rating to AA+ from AAA in August, while Standard & Poor’s Ratings did That was in 2011). However, this latest action shows Moody’s clear concern about the government’s ability to repay its growing $33 trillion debt pile amid a climate of sharply rising borrowing costs.

If Moody’s negative outlook is followed by a credit downgrade, rising concerns about US debt could profoundly impact yields, with the country’s increasingly exposed financial and monetary vulnerabilities reinforcing this “new normal” narrative for bond markets. “In the context of rising interest rates, and without effective fiscal policy measures to reduce government spending or increase revenues, Moody’s expects the US fiscal deficit to remain very large, significantly weakening debt sustainability,” the rating company noted. Moody’s also pointed out the continued political polarization within the US Congress, which “increases the risk of successive governments being unable to reach consensus on a fiscal plan to slow the decline in debt sustainability.”

However, there is still enough near-term demand in the market to suggest that a decisive reversal in yields is not completely out of the question heading into 2024, especially if inflation can be contained ahead of schedule. “Longer term, we’re very bullish on Treasuries and market rates, and we think they offer really good value,” said Jamie Patton, co-head of global interest rates at Los Angeles-based investment firm TCW Group (with nearly $200 billion under management). , He said Bloomberg After purchasing 30-year Treasury bonds at the November 9 auction. “Never, in the history of modern monetary policy, have we seen the Fed raise interest rates by more than 500 basis points and there not been an accident, correction or recession.”