Over the past month, the upswing in US economic data has led the market to sharply raise their estimates for the peak Fed Funds rate. As a result, the 10-year US government bond yield has jumped from around 3.3% to 4% in a span of few weeks. However, as I discuss in this article, the sharp swing in rate expectations is starting to look like a classic knee-jerk reaction and offers a compelling entry point into high quality bonds and income-oriented assets.
Echos of 2022
Viewed through a narrow lens, market trends in February 2023 appears to be uncannily similar to early 2022 on a number of parameters
- Markets are concerned about inflation being more persistent than expectations
- Labour market data is showing signs of strength
- Expectations of the pace and level of Fed rate hikes are being revised higher
However, if we step back and look at the broader picture, there are some key differences which investors would ignore at their own peril
- Unlike near-zero Fed Funds rate at the beginning of 2022, the rate today is at the highest level in nearly 15 years
- Inflation has actually been declining over the past few months. While the pace of decline may be slower than what the Fed and markets want, the direction of travel is still the right one
- Apart from US labour market data, a number of economic indicators, including housing have been showing signs of weakness and concerns about a Fed-induced recession are substantially higher than they were a year ago.
Are markets really (ir)rational?
One of the most vivid memories from my MBA classes at the Indian Institute of Management, Ahmedabad, is wondering why most of the theories and models were based on the “Efficient Market Hypothesis”, when our professors were always quick to highlight that the biggest caveat was that the markets are rarely rationale. Over the past decade, I have come across a number of instances where it was difficult to logically explain the market reaction to various events. I have had the same nagging feeling in the past few months again.
In January, US inflation declined in line with market expectations. How did markets react? The US 10-year government bond yield fell by over 50bps as markets all but eliminated further Fed rate hikes and started pricing in hefty rate cuts. All this because inflation declined in line with expectations!
Fast forward to a month later in February, inflation again declined, but to a lesser extent than what the markets expected. Markets reacted by raising the expected peak Fed Funds by nearly 65bps; the 10-year bond yield rose by almost 70bps. Would a rational market react so sharply to monthly data?
Admittedly, Fed members have sounded hawkish as well after the latest inflation data. But, in reality, their guidance has not changed much over the past 2 months. So, pinning the market swings on a hawkish Fed appears nothing more than a lazy excuse.
Bond market investors are generally seen as taking a longer-term view on bond yields and return expectations, relative to other asset classes. As shown in the charts below, over the past year, it appears that long-term bond yields have become closely corelated to near-term Fed rate hike expectations.
Fig 1: Historically, long-term bond yields have had limited correlation with near-term interest rate expectations….
US 10-year Treasury Yield and market-implied 12-month forward Fed Funds rate
From a logical perspective, long-term bond yields should be guided by expectations of average Fed Funds rate over the pertinent time horizon, which is significantly driven by expectations of long-term inflation, and the premium that investors demand to lend to the US government over a longer-term horizon (the so-called “term premium”). However, the tight correlation with short-term rate hike expectations over the past year appears to be a signal that markets may not be behaving efficiently.
Great opportunity to rotate into bonds and income assets
Given the above, the recent rise in yields is starting to look like an extremely crowded trade. As shown in Figure 2, the speculative positioning for higher yields (falling bond prices) now is the most extreme since 2018. In essence, a greater proportion of investors are now betting for the 10-year bond yield to rise when the yield is close to 4%, than they were at the start of 2022, when the 10-year yield was at 1.5%.
Fig 2: Investor positioning for higher bond yields is the most extreme since 2018
CFTC 10-year US Treasury Futures net positioning as a percentage of the Open Interest
It is certainly possible that the US 10-year government bond yield makes a final push towards 4.25% before eventually heading lower. It is completely understandable that after being 'bitten’ by the rapid rise in yields last year, investors may be ‘twice shy’ about being too early in adding allocation to bonds.
However, the perceived lack of rational behaviour in markets and the stretched speculative positioning appears to offer a great opportunity for investors to rotate into high quality bonds and income assets and lock in the attractive yields for the next few years.
Abhilash Narayan is a Senior Investment Strategist at Standard Chartered’s Wealth Management CIO office