BofA’s Warning of a ‘5% World’ Sinks in With Yields Pushing Higher
All around the world, bond traders are finally coming to the realization that the rock-bottom yields of recent history might be gone for good. The surprisingly resilient US economy, ballooning debt and deficits, and escalating concerns that the Federal Reserve will hold interest rates high are driving yields on the longest-dated Treasuries back to the highest levels in over a decade. That’s prompted a rethink of what “normal” in the Treasury market will look like.
At Bank of America Corp., strategists are warning investors to brace for the return of the “5% world” that prevailed before the global financial crisis ushered in a long era of near-zero US rates. And BlackRock Inc. and Pacific Investment Management Co. say inflation could remain stubbornly above the Fed’s target, leaving room for long-term yields to push even higher.
“There is a remarkable repricing higher in longer-term rates,” said Jean Boivin, a former Bank of Canada official who now heads the BlackRock Investment Institute. “The market is coming more to the view that there is going to be long-term inflation pressures despite recent progress. Macro uncertainty is going to remain the story for the next few years, and that requires greater compensation to own long-dated bonds.”
It’s a sharp break for markets that last year started positioning for a recession that would push the Fed to ease monetary policy, raising hopes for a sharp rebound from a brutal 2022 that sent Treasuries to the deepest losses since at least the early 1970s.
While higher rates will soften the blow by boosting bondholders’ interest payments, they also threaten to weigh on everything from consumer spending and home sales to the prices of high-flying tech stocks. What’s more, they will increase the US government’s financing costs, worsening the deficits that are already forcing it to borrow some $1 trillion this quarter to cover the gap.
The selloff since last week has hit those long bonds the hardest and wiped out the broader Treasury market’s gains this year, putting it on pace for the third straight annual loss. It has also pulled down stock prices, which rallied strongly until this month on expectations about the Fed’s path.
It’s possible the latest turn will prove off base, and some Wall Street forecasters are still calling for an economic contraction that would put downward pressure on consumer prices. Moreover, inflation expectations have remained moored this year as the pace slowed sharply from last year’s highs, a sign the market is anticipating it will eventually draw back near the Fed’s 2% target.
But many now expect a soft landing that would leave inflation the dominant risk. That was underscored this week by the release of the Federal Open Market Committee’s meeting minutes from July, when officials expressed concern that more rate hikes may still be needed. They also indicated the Fed may keep paring its bond holdings even when they decide to ease rates to make policy less restrictive, threatening to keep another drag on the bond market.
That helped to push Treasury yields up for a sixth straight day Thursday, with those on benchmark 10-year notes climbing as high as 4.33%. That’s just shy of the October peak, which was the highest since 2007. Thirty-year yields hit 4.42%, a 12-year high.
Broader economic shifts are also driving speculation that the low rates and inflation of the post-crisis period were an anomaly. Among them: demographics that may push up wages as aging workers retire; a shift away from globalization; and drives to combat global warming by shifting away from fossil fuels. “If inflation is going to be sticky and high, I don’t want to own long-term bonds,” said Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group. “People are going to need more term premium to own long-term bonds,” she said, referring to the higher payments investors normally demand for the risk of parting with their money for longer.
Even with the recent rise in yields, though, no such premium has returned. In fact, it remains negative as long-term rates hold below short-term ones — an inversion of the yield curve that’s usually seen as a harbinger of a recession. But that gap has started to narrow, cutting a New York Fed measure of the term premium to around minus 0.56% from nearly 1% in mid-July.
That upward pressure has also been exacerbated by US federal spending, which is creating a flood of new debt sales to plug the deficit even as the economy remains at, or near, full employment. At the same time, the Bank of Japan’s decision to finally allow 10-year yields there to push higher will likely cut Japanese demand for US Treasuries.
BlackRock’s Boivin says there’s a major shift underway at the world’s central banks. For years, he said, they kept interest rates well below the rate that’s considered neutral to spur their economies and ward off the risk of deflation. “This has been flipped now,” he said. “So even if the long-term neutral rate is not changed, central banks will hold policy above that neutral rate to stave off inflationary pressure.”
Key Takeaways:
- Bond traders are realizing that rock-bottom yields might be gone for good, prompting a reconsideration of what a “normal” Treasury market will look like.
- Bank of America warns investors to prepare for the return of a “5% world” and inflation that could remain above the Fed’s target.
- The recent rise in yields has hit long bonds the hardest, wiping out gains in the broader Treasury market and causing concerns about the impact on consumer spending, home sales, and tech stock prices.
- Several factors, including demographics, a shift away from globalization, and efforts to combat climate change, are driving speculation that the low rates and inflation of the post-crisis period were an anomaly.
- The Federal Reserve indicated the possibility of more rate hikes and continued bond holdings reductions, contributing to the upward pressure on Treasury yields.
- The US government’s increasing financing costs and flood of new debt sales, along with reduced Japanese demand for US Treasuries, are exacerbating the rise in yields.
- BlackRock’s Jean Boivin points to a major shift at central banks, which are now holding policy rates above the neutral rate to counter inflationary pressure.
Analysis:
The recent surge in Treasury yields is awakening bond traders to the possibility that the historically low interest rates of the past could be a thing of the past. Bank of America warns investors to prepare for a “5% world,” referring to the return of higher long-term rates that prevailed before the global financial crisis. This shift in sentiment has prompted a reshape of the Treasury market’s perception of what is considered “normal.”
The unexpectedly robust US economy, rising debt and deficits, along with concerns of the Federal Reserve holding interest rates at higher levels, are all contributing to the upward pressure on Treasury yields. BlackRock and Pacific Investment Management Co. acknowledge the potential for inflation to exceed the Fed’s target, indicating the possibility of even higher long-term yields.
The market is witnessing a remarkable repricing of longer-term rates due to the expectation of long-term inflation pressures. Despite recent progress, macro uncertainty is expected to persist for the next few years, necessitating higher compensation for owning long-dated bonds. However, some Wall Street forecasters continue to anticipate an economic contraction that would exert downward pressure on consumer prices.
One of the main concerns related to higher rates is the potential impact on various sectors, including consumer spending, home sales, and the valuation of tech stocks. Additionally, the US government’s financing costs will increase, exacerbating its already significant deficits. The recent selloff in long bonds has led to losses in the Treasury market and has also contributed to the decline in stock prices.
While some speculate that inflation expectations will eventually draw back near the Fed’s 2% target, many anticipate a soft landing that would leave inflation as a dominant risk. The release of the Federal Open Market Committee’s meeting minutes from July revealed concerns among officials that more rate hikes may still be needed. They also indicated that the Fed may continue reducing its bond holdings even when it decides to ease rates, further impacting the bond market.
One factor driving speculation about the anomaly of low rates and inflation in the post-crisis era is demographics. As aging workers retire, wages could increase, adding to inflationary pressures. The shift away from globalization, as well as efforts to combat climate change by transitioning away from fossil fuels, are also factors contributing to economic shifts. Kathryn Kaminski of AlphaSimplex Group expressed hesitation about owning long-term bonds if inflation remains high, citing the need for investors to demand higher term premiums for longer periods.
Although yields have risen in recent times, the term premium, which represents the additional payments investors normally require for the risk of parting with their money for longer, remains negative. This negative term premium is unusual and suggests the inversion of the yield curve, which is typically seen as a harbinger of a recession. However, the gap between long-term and short-term rates is narrowing.
US federal spending is another contributing factor to the upward pressure on yields. The government’s flood of new debt sales aimed at addressing the deficit, combined with the Bank of Japan’s decision to allow its 10-year yields to rise, will likely reduce Japanese demand for US Treasuries.
In summary, there is a major shift underway at central banks, according to BlackRock’s Jean Boivin. In recent years, central banks maintained interest rates below the neutral rate to stimulate economies and mitigate deflationary risks. However, the trend has now reversed, with central banks holding policy rates above the neutral rate to counter inflationary pressures. This signifies a significant change in approach.
Conclusion:
The recent surge in Treasury yields has challenged the belief that rock-bottom rates are here to stay. While there is still uncertainty about the future path of rates and inflation, it is crucial for investors to carefully assess their portfolios and consider the potential impact of rising rates on various sectors.
With long-term yields on the rise, it may be prudent to evaluate the risk-reward profile of owning long-dated bonds. Higher rates can lead to increased interest payments for bondholders, softening the blow, but they can also dampen consumer spending, home sales, and the prices of tech stocks. Additionally, the US government’s financing costs will escalate, worsening already significant deficits.
When constructing a diversified investment portfolio, it’s important to consider the potential impact of changing rates on different asset classes. This may involve allocating a portion of the portfolio to assets that can benefit from rising rates, such as inflation-linked bonds or sectors that historically perform well during inflationary periods.
Investors should closely monitor the actions and statements of central banks and stay informed about economic indicators to navigate the evolving rate and inflation environment. Regularly reassessing investment strategies and adjusting portfolios accordingly can position investors to adapt to changing market conditions.
Reference: BofA’s Warning of a ‘5% World’ Sinks in With Yields Pushing Higher