A mere three months ago, bond traders were a fairly relaxed group of people.
The 10-year Treasury bond yielded a modest 1.52% per year and had been trading around that mark for nine straight months. While inflation was bumping up, the Federal Reserve assured the markets it was transitory due to pandemic-related inefficiencies and there was no need for concern.
The first few months of 2022 have shattered bond traders’ serenity with Treasury yields rising (and, therfore, bond prices falling) significantly in just three months:
|Treasury term||12/31/2021 rate||3/25/2022 rate||% yield change|
Source: US Treasury
Additionally, traders’ speculation about future Federal Reserve rate hikes created a yield curve inversion – something you will likely hear about in the coming days and weeks.
Typically shorter-term bonds offer investors a lower interest rate while longer-term bonds offer a higher interest rate. This makes sense as there is less time for negative variables to impact investors’ total return.
As of Friday, bond traders created a yield inversion by pushing the yield on 5-year Treasuries higher than 10-year Treasuries, expressing their opinion that there are more risks in the next 5 years than the 5 years after that.
Persistent yield curve inversions can be an early warning sign of a potential recession within the next 12-18 months. However, while most recessions are preceded by a yield curve inversion, all yield curve inversions do not precede future recessions. Sometimes traders are simply too pessimistic about the future.
Right now traders are pricing in a very aggressive Federal Reserve rate hike schedule which is boosting the yields on shorter-term Treasuries. According to the CME FedWatch Tool, traders are expecting the Federal Reserve to raise its overnight lending rate by .50% on May 4, June 15, and July 27 for a total of 1.50% in the next four months.
By July 2023, traders have priced in an overnight lending rate of 3.25% to 3.50% which we have not seen since before the Global Financial Crisis in 2007.
Will bond traders’ current serenity-shattered yield-inverting economic opinions come true? Or will the Federal Reserve take a more measured approach to its rate hikes to reduce the risk of a future recession? We flat out do not know.
What we do know is that, depending on the individual investment and inflation risks built into our clients unique portfolios, we had prepared for rising interest rates by reducing our strategic allocation to interest-rate sensitive bonds. We also know that when traders potentially overreact the opportunity may exist for future unexpected positive returns.
We also know that our commitment to maintaining a diversified portfolio that is consistent with your financial plan does not waver in volatile markets. If anything, our resolution grows stronger.
Quote of the week: Daniel Kahneman: “Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance.”
Securities offered through LPL Financial. Member FINRA/SIPC. Investment advice offered through IAG Wealth Partners, LLC, (IAG) a registered investment advisor and separate entity from LPL Financial. Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Any opinions are those of IAG and not necessarily those of LPL Financial. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. No strategy assures success or protects against loss. Investing involves risk including loss of principal.