Bond Managers Sense Opportunity With Yields Below Fed’s Rate

(Bloomberg) — A sense of conviction that bonds should be bought is helping fund managers put the worst year in a generation behind them.

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Even as the Federal Reserve has made clear it intends to raise rates further to insure continued progress on inflation, and that it’s not contemplating the eventual rate cuts traders are pricing in, investors are already being rewarded for seeing value in the Treasury market. With this week’s increase to 4.25%-4.5%, the central bank’s range for the federal funds rate exceeds the highest-yielding Treasury securities — a warning to investors against waiting any longer to buy.

On several occasions this week, intraday spikes in yield dissipated quickly, a sign that buyers are pouncing on them. The first occurred after the Fed decision Wednesday, spurred by policy makers’ upwardly revised median forecasts for the eventual peak in the policy rate and for inflation. Over the next two days, a deep selloff in euro-zone government bonds sparked by hawkish European Central Bank commentary caused only temporary cheapening in US rates. A steep drop in Treasury volatility this week after the Fed decision boosted investor confidence that yields won’t attain new highs.

The interest in buying bonds reflects the view that inflation probably has peaked and will fall sharply, even if the Fed isn’t ready to draw that conclusion. Also that the four percentage point increase in the policy rate since March is sowing the seeds of a recession that will lead eventually to rate cuts, if not in 2023 then in 2024.

“We believe that the outlook for 2023 is starting to brighten,” said Marion Le Morhedec, global head of fixed income at AXA Investment Managers SA. The rise in rates we’ve seen this year “adds to the attractiveness of the bond market” and central bank tightening “seems to be mostly behind us.”

Except for the two-year note’s — more sensitive than longer-maturity yields to the level of the Fed’s policy rate — rates across the Treasury spectrum are back below 4%. The two-year peaked at nearly 4.80% last month, the 10-year near 4.34% in October, both multiyear highs. The corresponding slump in bond prices erased as much as 15% of the value of the Bloomberg Treasury Index this year. While the loss has been pared to about 11%, it’s still the worst in the index’s five-decade history.

The 10-year note’s yield approached 3.40% this month, aided by signs of moderating inflation in the October and November consumer price index reports, and Fed Chair Jerome Powell previewing the slower pace of rate hikes the central bank adopted with its half-point hike on Dec. 14.

To be sure, the drop in yields from their highs raises the stakes for investors who think now’s the time to buy. The new median forecasts of Fed policy makers released after this week’s meeting showed they expect a higher peak for the fed funds rate of 5.1% next year to cope with an increased core inflation forecast to 3.5%.

Powell in the news conference following the meeting emphasized that because the labor market has yet to show any meaningful signs of softening, its unclear how long the policy rate will need to remain at its eventual peak. At the same time, policy makers’ median forecasts for 2024 include a decline in the funds rate to 4.125%.

“A 10-year at 3.5% does look a little too low, but at the same time it’s difficult to see upward pressure on government bond yields when inflation is starting to co-operate,” said Andrzej Skiba, head of the BlueBay US fixed income team at RBC Global Asset Management.

Next week, personal income and spending data for November are expected to show a decline in the core inflation rate to 4.6%, the lowest since October 2021. The University of Michigan’s December sentiment survey, to be revised next week, found consumers expect 4.6% inflation over the next year, also the lowest in more than a year.

Market-implied inflation expectations also have waned, with the breakeven rate for five-year Treasury inflation-protected securities approaching its year-to-date lows around 2.20%. That suggests investors have confidence the Fed will succeed in wrestling the CPI rate, 7.1% in November, down further from its June peak of 9.1%.

San Francisco Fed President Mary Daly, speaking Friday, said the central bank remains far from its price stability goal and has “a long way to go.” Bond traders weren’t fazed.

Seasonal dynamics complicate the analysis, however, said Michael de Pass, head of linear rates at Citadel Securities.

The bullish bond market tone “may reflect year-end flows as money moves into bonds amid low liquidity,” he said.

But after 400 basis points of rate hikes, a hawkish Fed no longer poses the same degree of danger to bond investors it once did, enabling them to draw different conclusions.

“The Fed has largely caught up to the situation on the ground,” de Pass said. “The market thinks the economy and labor market will deteriorate far more materially than the Fed does.”

What to Watch

Economic calendar:
- Dec. 19: NAHB housing market index
- Dec. 20: Housing starts
- Dec. 21: MBA mortgage applications; current account balance; existing home sales; Conference Board consumer confidence
- Dec. 22: 3Q GDP final revision; weekly jobless claims; Leading Index; Kansas City Fed manufacturing activity
- Dec. 23: Personal income and spending; durable goods orders; new home sales; University of Michigan sentiment survey
Fed calendar:
Auction calendar:
- Dec. 19: 13-week; 26-week bills
- Dec. 21: 17-week bills; 20-year bond
- Dec. 22: 4-week, 8-week bills; 5yr TIPS