By Garfield Reynolds, Bloomberg Markets commentator and analyst
The extraordinary rally in Treasuries that defied last week’s red-hot inflation print looks set to cement the 3% barrier as a hard ceiling for yields, and that makes it possible this year’s cross-asset crash is the start of a years-long downtrend.
The turnaround in sentiment among investors was almost as rapid as the shift from Federal Reserve Chairman Jerome Powell and the ultimate message is the same. Even with unemployment close to the lowest since the 1960s, and central bank officials saying that the US economy is in robust health, equities are acting as though yields above 3% are more than businesses can cope with.
Then again, this was in many ways a bond rally that was waiting to happen. That’s because 10-year yields had already gone as far and fast as at almost any stage in the past 30 years. Based on the past three decades, the 207 basis point increase from August 2021’s trough to the May 9 peak at 3.20% is set to be as high as yields get for a while to come.
Looking back at 10 episodes since 1992 when 10-year yields climbed from trough to peak, this was already the largest increase since the 2003-2007 Treasuries rout added 225 basis points. The table below examines moves of at least 100 basis points that also involved discernible and sustained sell offs.
On the surface, this seems like a cause for optimism for investors. The harsh selling that sent global government bonds to their worst losses on record may be drawing to a close, removing a danger for risk assets that have slid as higher yields made historically excessive valuations harder to justify.
The problem is that inflation looks way too elevated for nominal yields to stay this low, or for the Fed to accept them at these levels. If 10-year yields stay under 3%, the gap to Fed funds will soon be 100bps or less with Powell committed to hiking 100bps to a 2% target ceiling by July. That would give the Fed little wiggle room considering the last three hiking cycles ended when 10-year yields slipped below the central bank rate.
Any bonds rally from here may be shallow, and if that then reverses to send yields back toward 3% the concern would be that equities and other risk assets again struggle to cope.
The Fed has shifted away from kind words about engineering a soft landing toward harsher truths about how a recession may be unavoidable — and that what they are focused on, above all, is inflation. Powell’s trenchantly hawkish comments Tuesday that he wants to keep hiking until it’s clear inflation is cooling underscored the dangers.
That signals an end to Fed puts for bonds and stocks, or at the very least much lower strikes at a time when a decline in China’s growth impulse and the geopolitical dislocations caused by Russia’s invasion of Ukraine are also creating strong headwinds for assets.