Age of Innocence for Bond Traders Ends in Latest Inflation Shock
Bond investors were hit by the latest annual reading on U.S. consumer prices that showed the fastest increase in four decades.
(Bloomberg) -- For the Treasury market, it was a one-two gut punch: The fastest rate of inflation since Ronald Reagan was president and a Federal Reserve official calling for a full percentage-point increase in interest rates by July.
The twin blow sparked big moves across global markets Thursday -- schooling anyone on Wall Street with lingering doubts that the hawkish monetary era has arrived.
Two-year yields jumped Thursday by the most in more than a decade as U.S. government bonds sold off across the curve. Ten-year yields rose above 2%. Stocks weren’t spared, with the S&P 500 closing down 1.8% amid fresh losses in speculative tech companies. While some relative calm returned to markets in early trading Friday, few are banking the worst is over.
Bond investors were hit by the latest annual reading on U.S. consumer prices that showed the fastest increase in four decades. Hours later, St. Louis Fed President James Bullard called for a concerted pace of policy tightening.
While Bullard’s view doesn’t reflect the consensus of Fed officials, his comments still spurred traders to launch ever-more aggressive wagers on upcoming interest-rate increases.
Goldman Sachs Group Inc.’s economists now expect the Fed to raise rates seven times this year, up from from five projected earlier. They don’t tip a 50 basis point move in March but said this may change if others join Bullard.
In contrast to him, other officials don’t appear to be in a rush to raise rates prior to their scheduled policy meeting next month, nor to favor a half percentage-point move in March yet.
“Short rates have been rising for months now in anticipation of a hawkish Fed,” said Jim Bianco, president of Bianco Research. “But the CPI report was almost a bridge too far. And if the Fed’s priority has shifted to inflation -- then get out of the way because here comes a lot of hikes.”
Bets that only weeks ago sounded far-fetched now have better-than-even odds: The swap market projects an over 90% chance of a 50 basis-point hike in March -- and close to 110 basis points all-in over the next three central-bank gatherings. Traders are even speculating on the idea of an inter-meeting increase in rates.
It all suggests the age of innocence is over for young bond traders lulled by the pre-pandemic years of disinflation.
Two-year Treasury yields rose over 20 basis points Thursday, the biggest one-day move since June 2009, while Treasury Secretary Janet Yellen’s debt managers had to pay up for an ill-timed 30-year bond sale. Down more than 3% so far in 2022, U.S. Treasuries could well close out the year in the red at this rate, in what would be the first back-to-back annual loss in history.
And with megacap companies falling, Max Gokhman, the chief investment officer at systematic money manager AlphaTrAI Inc., says more investors are fading the so-called Fed put, or the idea U.S. policy makers will step in to support financial markets at the first sign of trouble.
“I think the market keeps having these realizations,” he said. “There will be more days like this.”
While stocks have historically tended to advance in the first year of policy tightening, the pace makes a big difference, according to Ned Davis Research, which defines a fast cycle as a hike per meeting. Since 1946, the S&P 500 fell 2.7% on average in this scenario while rising 11% during slower ones.
Unlike in the past, when the Fed tended to raise rates amid accelerating growth, this time is different when it comes to corporate earnings. Profits from S&P 500 firms are expected to increase 7% this year, down from 50% in 2021, data compiled by Bloomberg Intelligence show.
All that suggests it’s time for investors to cut equity holdings and raise cash to prep for more market turmoil, said Ed Clissold, a strategist at Ned Davis.
Bond investors could be set for more pain too. At quant shop AlphaSimplex Group LLC, Kathryn Kaminski says technical signals remain ultra bearish across the asset class. That suggests the Thursday data should be a wake-up call to anyone still downplaying the threat of elevated price pressures.
“People were sitting there thinking ‘well, inflation is going to go away because Covid has calmed down some, so the Fed isn’t going to act,’” said the portfolio manager and chief research strategist. “But the inflation print of 7.5%, worse than last month, made them realize this is really happening.”
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