Central banks have ramped up their hawkish rhetoric this month but for bond bulls, that’s a good thing.
Investors are piling into longer-dated notes on bets that policy makers will succeed in taming inflation, an outcome that will deliver strong and stable returns on debt. Benchmark 10-year Treasury yields have fallen 10 basis points this year to 3.77% even after the Federal Reserve jacked up interest rates aggressively and vowed to keep hiking.
Undeterred by a record 12% loss in U.S. bonds last year, investors are wagering that central banks will finally be able to get a handle on inflation as growth slows and supply chain disruptions ease. They risk being caught flat-footed if price gains prove to be more stubborn than expected, forcing authorities to keep borrowing costs higher for longer.
“We are in an ironic situation where the more hawkish central banks are in hiking rates, the better it is for inflation credibility and long-term yield stability, assuming that there are no fiscal upsets along the way like in the UK last year,” said Chang Wei Liang, a strategist at DBS Bank Ltd. “This is true if markets see long-term inflation expectations as being anchored at close to 2%, and if they view long-term growth rates to be no higher than what they are today.”
Analysts in a Bloomberg survey predict that the 10-year U.S. yield will decline to 3.39% by year-end. Treasuries have lost almost 2% over the past three months, paring this year’s gain to about 1.6%, according to a Bloomberg index.
“A 10-year Treasury is sort of 10 years of patience to average out where the policy rate will be — the bond market is believing that this inflation was an aberration,” Steven Wieting, the New York-based chief investment strategist at Citi Global Wealth Investments, said at a briefing in Singapore. “We’re not headed to 4.5% or 4.25% even — I think that we will be headed somewhat lower in yield levels.”
Recent declines in bond markets were focused at the short end as central banks from the UK to the US vowed to keep up the fight against inflation, damping expectations that policy makers can soften their stance as price pressures ease.
There may also be other factors in play that are propping up demand for longer-dated notes.
“Large pools of pension funds with long-dated liabilities will need to be invested in long-dated bonds no matter what, and tail risks of a recession could also lead to hedging with long-term bonds,” said DBS’ Chang.
Traders in forwards markets are also recalibrating their bets to reflect the confidence in central banks. They expect 10-year Treasury yields to rise about 60 basis points over the coming year, near the bottom of the three-month range. The projection at the start of 2023 was for an increase of more than 100 basis points.
“While hawkish central banks and recent more aggressive hikes from some have pushed up front end yields, long-end bonds have been stable, not due to recession fears so much, but comfort that policy makers are serious about bringing inflation down,” said Khoon Goh, head of Asia research at Australia & New Zealand Banking Group Ltd. “In short, it is a vote of confidence in the credibility of central bankers.”
