(Bloomberg) – The US bond market is heading towards the clearest sign yet that the Federal Reserve’s shift to a hawkish gear is making a difference – a real 10-year yield higher than 0%.
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While all government interest rates have risen this year as the Fed began what is expected to be an aggressive series of rate hikes aimed at curbing high inflation, the baton has in the past two weeks been passed on to inflation-protected banknotes and bonds. Their returns are called “real” because they represent the rates investors will accept as long as they are paired with extra payments to counter inflation.
For borrowers, whose incomes may rise with inflation, the real interest rate represents a kind of true price of money. For 10-year loans, it has been negative since the beginning of 2019, except briefly during the market chaos in March 2020. Ten-year real interest rates on inflation-linked government bonds rose to -0.15% from -0.49% in the past week. The low was -1.26% in November.
“The Fed’s tighter policy should fundamentally argue for higher real interest rates,” said Michael Cloherty, head of US interest rate strategy at UBS AG’s securities division.
The time of negative real interest rates supported the demand for more risky assets – loosened financial conditions. To get inflation under control again, the Fed needs to tighten them via higher real interest rates. The pace may be higher this time. At the end of 2018, the 10-year real interest rate rose above 1% after leaving negative territory in 2016, when the Fed slowly tightened policy.
Market expectations for how much the central bank will raise its key interest rate have exploded higher, with futures linked to Fed meeting dates now priced to peak at around 3.15% by mid-2023, up from 0.25% – 0.5% at the moment. Chief Economist Jan Hatzius of Goldman Sachs Group Inc. said Friday that it was possible to imagine circumstances under which it could exceed 4%.
“A real return above zero means valuations of stocks, and all assets need to be revalued,” said David Bianco, Chief Investment Officer, Americas for DWS. Fed officials “sound very convincing about fighting runaway inflation and they will act.”
In the two weeks following Russia’s invasion of Ukraine on 23 February, and after rising commodity prices boosting demand for inflation-linked bonds, real interest rates briefly dipped back towards last year’s lows. The differences in returns between inflation-protected and ordinary government debt – which represent the amount of inflation needed to offset their returns – widened, in some cases to the highest levels ever in the last two decades.
The subsequent recovery in interest rates to the highest levels since before the pandemic has been led by real interest rates, however, a sign that investors expect the Fed to succeed in bringing inflation under control.
The US Consumer Price Index for March, released on Tuesday, is expected to show a month-on-month increase of 1.2% – higher than any other since September 2005 – raising annual interest rates to 8.4%, most recently in 1982.
Normally, a strengthening economy raises real interest rates and inflation expectations at the same time, but an aggressive Fed sets the stage for these to diverge, creating “extreme volatility in TIPS,” Cloherty said.
A Treasury index for inflation-linked securities has lost 3.3% since March 23 to a total return of -4.7% in 2022. While comparable ordinary government bonds have performed even worse – with a year-to-date total return of minus 7.8% – they have performed better in the recent period and have lost only 2.4%.
The underperformance in TIPS deepened with the revelations – first by Fed Governor Lael Brainard on Tuesday, then in the minutes of the March Federal Open Market Committee meeting on Wednesday – that balance sheet losses would begin faster and unfold faster than any market expected participants.
The minutes showed that the Fed is set to start shrinking its balance sheet next month by not replacing all the overdue government bonds and collateralised securities it has. The last time the Fed made so-called quantitative easing, from 2017 to 2019, it set monthly limits on how much of its expired holdings would not be replaced with new securities.
The minutes suggested that the total runoff ceiling could reach $ 95 billion within three months. While the peak cap was in line with bond traders’ expectations, the pace was faster than some predicted.
As the Fed extended its balance sheet from March 2020 to March 2020, TIPS performed better because central banks’ purchases of TIPS accounted for a larger share of the outstanding amount. The $ 256 billion increase in its TIPS portfolio to $ 388 billion – more than one-fifth of the market – exceeded market growth over the same period.
“The Fed became a major buyer of TIPS, and now they are not buying,” said George Goncalves, head of macro strategy at MUFG. “On the margin, QT means more to TIPS than the broader financial market.”
Meanwhile, investors who joined the iShares TIPS Bond ETF last year have been net redeemers this year.
Ruffer LLP, an institutional investment manager of about $ 33 billion, recommends short-term TIPS for inflation protection, which have less price sensitivity than the broad market to rising interest rates.
“The Fed and retail are buyers of TIPS, and both are going away,” said Alex Lennard, chief investment officer at Ruffer in London.
The recent resilience of US stocks has helped boost confidence that the Fed’s key interest rate will reach 3.25%, and the potential implications for the dollar of the geopolitical adjustments triggered by the Ukraine crisis have deepened investors into unknown territory, said Glen Capelo, CEO. director of Mischler Financial.
“The Fed has not been tightening solely because of inflation since the early ’80s,” he said. “This is the first time they’re really tightening up while running QE at the same time.”
What to see
April 12: CPI, NFIB small business optimism
April 13: MBA applications for mortgages; PPI
April 14: Unemployment claims, corporate stocks, retail sales, University of Michigan sentiment and inflation expectations
April 11: Atlanta Fed President Raphael Bostic, Governor Michelle Bowman, Governor Christopher Waller, Chicago Fed President Charles Evans
April 12: Governor Brainard, Richmond Fed President Thomas Barkin
April 14: Cleveland Fed President Loretta Mester, Philadelphia Fed President Patrick Harker
April 11: 13- and 26-week bills, 3-year notes
April 12: 10-year notes
April 13: 30-year bonds
April 14: 4- and 8-week bills
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