It’s like 2022 all over again, with 10-year US Treasury yields approaching 4%, equity markets struggling and the dollar strengthening. But now is not the time to abandon all hope and jettison fixed-income positions. Instead, investors should be contemplating where to add to their bond holdings, not reducing them.
Other bond markets are hostage to the shifts in Treasuries, where yields are being driven higher as the market anticipates the Federal Reserve will continue to tighten aggressively. Shorter maturities are leading the way, with the two-year US yield back up to the November peak of 4.7% and close to its highest since the global financial crisis. German two-year yields near 3% show a similar story. Further central bank rate hikes are being priced in across the globe, partly in reaction to the dollar index firming by 3% so far this month. Dollar strength, driven by rising yields, reverberates far and wide. Deutsche Bank AG analysts have raised their European Central Bank peak rate expectations to 3.75% from 3.25%. An uptick in geopolitical tension, at the one-year mark of the start of the war in Ukraine, isn’t helping sentiment.
The minutes from the most recent Fed meeting on Feb. 1 are due on Wednesday. Though subsequent economic data has been stronger than anticipated, it ought to shed light on what comes next. Fed Chair Jerome Powell only three weeks ago made clear that the impact of 450 basis points of tightening since March will have lagging negative impact on the economy, adding that he sees signs of disinflation. In his Wednesday morning note, Deutsche Bank Chief Macro Strategist Jim Reid advises “don’t confuse recent strength in data as a soft landing. It’s not until year two onwards of the hiking cycle that pain normally starts to be felt.”
Investors would do well to to pay more attention to more senior Fed policymakers than outliers such as St. Louis Fed President James Bullard, who seems to specialize in either being the most dovish or hawkish depending on which way the wind is blowing. Bullard said he was open to a 50 basis-point hike next month, but refrained from actually advocating one. It’s obvious there is a range of views but neither he nor Cleveland Fed President Loretta Mester, who sees a compelling case for a bigger hike, have votes this year. There is more of a dovish tilt from the new voting members who have joined recently.
A barnstormer of a US jobs report earlier this month has changed the narrative; with 2023 no longer interpreted as reversing the market misery of last year. Economic commentary has shifted from a possible hard landing, skipping through a soft landing, to the prospect of no landing at all. That seems wishful thinking. It’s possible the annual revision of seasonal adjustments in the January payroll data, along with lack of snow in January, helped embellish the 517,000 monthly gain in jobs. The next labor market report for February due on March 3 will either confirm the economy is in ruder health than presumed at the start of this year, or show a more balanced perspective for the Fed to cogitate on. Certainly the flash February purchasing managers’ surveys across most of the developed world have shown improvement, bar a weak spot in European manufacturing.
It’s clear the Fed is not going to pause, but will hike again at its March 22 meeting; it’s far more likely, though, to deliver a repeat of February’s 25 basis-point move, rather than a half-point increase. Reverting to bigger steps would send a message of having lost control if, after slowing from the aggressive pace of 2022, the FOMC felt the need to step harder again on the monetary brakes; the futures market sees just a 20% chance of a 50 basis-point increase. Nonetheless, the Fed will probably be delighted that the prospect of rate cuts at the back end of this year are no longer priced in. That will be far more important for their outlook on financial conditions.
Higher for longer is likely to become the Fed mantra, rather than much higher rates from here. With quantitative tightening yet to have much of an impact, as liquidity from other sources at the Fed and the US Treasury has flooded into the monetary system, there are plenty of technical reasons for the Fed to be cautious, not least of which the ongoing tussle in Washington of extending the debt ceiling. A correction from the early optimism at the start of the year was probably overdue, as often happens in February, but the fundamental picture for fixed income is still very unclear with the economy in a state of flux. Play the range; with so much bad news already priced in, now is not the time to become a bond bear.
More From Bloomberg Opinion:
• Inflation’s Slowdown Is Less Than Meets the Eye: Richard Cookson
• Treasury Bill Rates at 5% Are Hardly a Bargain: Aaron Brown
• Fed Pivot Is Dead. Long Live the Fed Pirouette: Robert Burgess
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.
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