The Weekly Fix: Rate-Hike Frenzy, Bonds Scent Inflation Peak
(Bloomberg) -- Welcome to the Weekly Fix, the newsletter where hiking is about central banks, not long walks in the countryside. I’m Bloomberg’s chief rates correspondent for Asia, Garfield Reynolds.
Inflated Rate Expectations
The December CPI report duly delivered the 7% annual inflation expected, the strongest reading in 39 years. While bonds met the release with calm (more on that later), rates traders marched triumphantly on with ever-more-aggressive wagers that the Federal Reserve will lead a round of rapid tightening moves worldwide. Even as Fed Chairman Jerome Powell channeled Hippocrates -- pledging to do no harm as he stamps out inflation -- his colleagues were busy racing to up the ante and persuade markets they are ready to jump ahead of the curve after being perceived as way behind it.
March pricing at a 90% chance for a hike is now looking conservative given the wave of Fed hawks. And the curve can steepen further seeing it is now based on 3.5 hikes by year-end, while Fed officials sounded like auction participants, opening with three hikes, raising that to four and then even compassing the potential for five.
All that proved very tough medicine for technology stocks to swallow, as investors judge the sector benefits more than most from low yields and so now will suffer from the coming regime change. A key part of the dynamics for bonds and stocks are the strong signs that central banks are willing to look past the omicron-fueled surge in the pandemic and stay the tightening course. The Bank of Korea underlined that dynamic in delivering a rate increase on Friday. Traders Down Under are also certain the Reserve Bank of Australia will be forced to raise rates way ahead of Governor Philip Lowe’s guidance, despite economists slashing first-quarter GDP forecasts as omicron disrupts consumer spending.
The perception that the pandemic is no longer solely a potential downside risk to economic growth helps explain why policy makers may prove to be more potent this year than the virus in their impact on the economy -- and that also raises the potential for a rare second-straight year of bond losses.
Transitory Yield Deflation
Returning as promised to bonds themselves, they were traveling fairly well for much of this week. Breakevens dropped on the day of the CPI report -- the biggest such decline in a decade -- and then extended the move the following day when a report showed producer prices decelerated. That shows that investors may be deciding that the recent runup in yields has gone far enough to make bonds worth buying and holding, especially if the Fed aggression mentioned above reins in inflation sooner rather than later.
There still look to be more reasons for bearishness than bullishness, as underscored by plenty of interest among options traders in buying protection against a 1.95% 10-year U.S. yield. One key concern is also the potential that the laws of supply and demand will return to global bond markets this year. Central banks are cutting back their bond purchases faster than governments are winding back spending, so the amount of sovereign bonds hitting the private sector is set to swell in 2022, adding pressure on yields to rise further.
That’s also causing higher volatility and some strong shifts in the way investors are deploying their money. Municipal bond investors just pulled money from high-yield mutual funds, possibly calling time on unprecedented inflows muni funds enjoyed for much of the last year.
There were also signs that the dynamics of corporate bond sales may be turning in favor of Treasuries, even if only in the short term. Investment-grade issuance soared at the start of the year as companies returned to the work of raising funds after a break over Christmas. That acted to enhance the runup in government bond yields fueled by rate-hike expectations, as well as setting off a vicious feedback loop. Borrowers rushing to tap the markets on fears yields would keep rising ended up sending yields up further — and that pushed more companies to sell bonds and, again, send Treasury yields higher.
The pause in the Treasuries rout came as issuance from corporates slowed. It may also have been helped by anticipation that the big banks will follow previous practice and sell bonds after they report earnings -- and those transactions usually help Treasuries because of their impact on swaps markets.
China Remains Concerning
The wild card for bonds, and assets more broadly, remains China. The slow-motion train wreck hitting its indebted property developers -- and threatening to crash the nation’s real-estate sector -- grinds on. Stress levels in China’s $870 billion overseas credit market climbed back to the highest possible reading in Bloomberg’s China credit tracker in December and there has been little this month to offer reassurance.
The property slump is likely to mean China posts its weakest economic growth in more than a year when it releases quarterly data Monday. News that several of China’s largest banks may have become more selective about funding real estate projects by local government financing vehicles to avoid getting drawn in to the mire can only add to concerns about the impact on growth. Most Chinese local governments saw revenue from land sales fall in 2021, damaging budgets just as Beijing calls for faster spending to pull the economy out of a downturn.
The issue is likely to keep China’s government yields declining -- they are close to the lowest since June 2020 -- at a time when most global peers are going the other way. The central bank in China is widely expected to keep on easing policy.
Among the better news this week was the fact that China Evergrande Group did manage to avoid what would have been the company’s first default on a public onshore bond, but that was only by obtaining creditors’ permission to delay payment. Shimao Group Holdings Ltd. is asking investors to extend the full payment on a pair of asset-backed securities too. So far the pain in Chinese developer bonds has had a fairly limited impact on markets more broadly, and investors outside China will be watching warily in hopes that continues.
Dollar doldrums: Traders rethinking play books as Fed rate-hike aggression actually weakens greenback
Hedging against inflation could be as simple as buying bonds in Japan where price pressures remain almost non-existent
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