Hold tight on the roller coaster!
Many investors expect the equity markets to be volatile, but in theory bond markets should be rather smoother. After all, their objective is to look at long-term issues such as the state of the business cycle rather than quarterly corporate earnings reports. Pension schemes and other long-term bond investors are very different to the vagaries of short-term hedge funds. However, the past few weeks have demonstrated a higher level of market volatility in fixed income than equities, as investors switch their attention back and forth from recession risk to inflation concern, from a focus on aggressive interest rate hikes to hopes for future rate cuts.
Such switch back investment decisions have led to the US benchmark bond yield reaching towards 3.5% a few weeks ago, then plunging closer to 2.7% before turning on a dime and rallying back towards 3.0%.
A key factor in this switch back cycle has been the weakness of economic data into the summer. After a further down step in ISM business survey data, including weak factory order books, the Atlanta Federal Reserve’s ‘GDP Now’ estimate indicates that US Q2 GDP might be down 2% on an annualised basis. However, other estimates are for positive if muted growth over the rest of the year.
Bond markets have also been prone to inflation fears and hopes. One consequence of the weakness in economic growth in the major economies, and the lack of a significant stimulus from China, has been concerns about a fall in demand for major commodities. The price of oil has fallen back towards $100 per barrel, suggesting sharp declines in petrol prices in coming weeks.
Central banks know, however, that they need to follow through with interest rate increases to quell future inflation pressures. Minutes of the most recent Federal Reserve meeting showed a concern amongst many Governors that “elevated levels of inflation could become entrenched if the public began to question the resolve of the committee to adjust the stance of policy as warranted”. Hence, the median view in the Summary of Economic Projections showed an interest rate midpoint of 3.375% at end-2022. Several hawkish members of the Fed this week argued strongly for 0.5% or 0.75% moves at the next few meetings, before easing off into the autumn.
Such views percolate through to currency markets, leading to further concerns for central banks. The US dollar continues to edge higher, and the Euro and Sterling lower – the former towards parity, the latter now below $1.20/$ – not helped of course by the considerable political uncertainty being experienced in the UK. If such a downward move in the Euro or Sterling gathers pace, then central bankers across Europe will start to worry about imported inflation – against the backdrop of a global food crisis reflecting the Ukraine war and climate change crises.
Central bankers such as Huw Pill, Chief Economist at the Bank of England, are trying to weigh up all these issues. While the MPC is not expecting to see any significant growth in the economy over the next year or so – he concludes “the current squeeze on real income threatens to create slack and downside risks to inflation further out” – he prefers a “steady-handed” approach, warning that big moves in rates could be counterproductive.
The net result of these conflicting forces has been a flattening of the yield curve in major bond markets, for example the spread between 2 and 10 year gilt yields in the UK is now only 0.25%. The real worry is the US yield curve, which is almost flat between 2 and 10 year bonds. If that starts to invert, that is 10 year yields fall significantly below 2 year, then more economists will warn about imminent recession, leading to more roller coaster moves in all financial markets.
Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 3.00 (+0.23) 3.02 (-0.02) 2.99 (-0.04)
UK 1.84 (+0.07) 1.78 (-0.10) 2.10 (-0.15)
Germany 0.55 (-0.15) 0.95 (-0.13) 1.30 (-0.06)
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making