Bonds recovering from a brutal year show the power of higher rates

(Bloomberg) — Wall Street is finding a reason to keep entering the bond market, even with a Federal Reserve that is still far from declaring victory in its war on inflation.

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The sell-off that hit investors with record losses during the first 10 months of the year also ended an era of record-low interest payments on Treasuries, driving yields to their highest in more than a decade.

Those coupon payments, now above 4% on recently issued 2- and 10-year notes, have grown large enough to attract buyers and are seen as a buffer against future price declines. The resilience of the economy is also strengthening the case: If the Fed needs to tighten monetary policy so much that it triggers a recession, Treasuries will likely recover as investors look for somewhere to hide.

“The coupon is becoming a more significant source of return now,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “The math of bonding is turning into a tailwind.”

The bond market gained support Wednesday as Fed Chairman Jerome Powell indicated that the central bank will likely slow the pace of its rate hikes at its December 13-14 meeting.

The comments fueled a rally that began in early November after the rate of consumer price inflation slowed. That led a Bloomberg Treasury index to gain more than 2% for the month, the first increase since July and the biggest since March 2020, when the onset of the Covid pandemic in the US spurred a run on higher assets. sure.

Powell’s temper of his hawkish tone has increased demand from investors looking to lock in current levels of yield or close short bets against bonds.

Continued buying pushed two-year Treasury yields from Wednesday’s high of 4.55% to a low of 4.18% early Friday, before yields moved higher after a stronger-than-than-ever November jobs report. planned. Off the curve, 5- and 10-year yields have continued to fall and remain at their lowest levels since September.

McIntyre warned that the market’s volatile ride may not be over, saying signs of persistently high inflation could limit the scope of future rallies or drive yields back up.

“While inflation is coming down, it still has a long way to go,” he said. “We don’t know when and if we will need a significant recession to achieve this.”

But Friday’s reaction to still rapid employment and wage growth shows the underlying support the market has gotten from raising rates over the past year. This has steadily increased coupon payments on bonds that the Treasury Department sells at auction.

“The trend of higher rates is definitely not going to go away overnight,” said Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group, whose public mutual fund is net fixed income and growing by over 34% this year. “But we have seen volatility rise continuously throughout the year. So the relative strength of the bearish signal versus volatility has become less strong.”

Furthermore, there were further signs of weakening growth and easing inflationary pressures. The consumer price gauge targeted by the Fed rose at a slower-than-expected pace in October, according to a report released on Thursday.

In the week ahead, investors will be watching data on the services economy, producer prices and inflation expectations for further signs of how rate hikes are affecting the economy. Fed policy makers will not speak until the mid-December meeting, when the central bank updates its economic projections.

Expectations that tighter monetary policy will slow the economy pushed the longest-dated bonds to their biggest gains since early November, with 30-year yields falling again on Friday. But short-dated bonds have also rallied over the past month, highlighting the appeal of higher coupon payments for investors looking to earn a yield through their maturity.

“We know retail advisors are happy to put clients in an investment that yields 4% for the next two years,” said Scott Solomon, associate portfolio manager at T. Rowe Price.

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