The jump in long-end U.S. Treasury yields over the past week has caused concern among bondholders that the trend could continue and become self-validating — regardless of what the Federal Reserve does or what reports indicate about the trajectory for economic activity.
It’s a warranted concern, especially since the “Taper Tantrum,” just three years ago, is easily remembered by current bond traders. During the latter half of 2013, the 10-year Treasury surged from about 1.65% to 3%, and the 30-year from 2.85% to 4%.
That environment also crushed many income vehicles, with arguably the biggest impact being on the mortgage real estate investment trusts (mREITs), which, on average, all declined about 50% during the same period.
Bond market participants have been on egg shells ever since, exhibiting a kind of post-traumatic stress response when yields start rising. A “fool me once, shame on you; fool me twice, shame on me” attitude has become prevalent for bond traders and other income-vehicle investors.
The current narrative is that if the 10-year can get to 1.60% it can get to 1.80%, 2%, 2.20%, etc. That may be a rational viewpoint, but it’s also leading to mental, and I think even physical, fatigue in bond traders and income seekers. I offer this from first-hand experience as our shop is principally an income-seeking one for clients and we spend more time discussing global interest rates, bond yields, currencies, and monetary and fiscal policies than anything else.
For institutional holders such as insurance companies that have to hold sovereigns as reserves no matter what happens to yields, the psychological issues aren’t as severe. For bond traders, though, with the principal objective of capital gains, the environment of the past several years has led to feelings that vacillate quickly and with increasing frequency between, “I’m rich, I’m broke, I’m a Seer, I’m a fool.”
And this has been amplified for the highly visible bond traders like Jeffrey Gundlach and Bill Gross, who are regularly referred to as “Bond Gods” by the financial media.
Putting aside macro and micro supporting arguments for either rising or falling bond yields, the pragmatic public narrative is that yields are likely rise. The pragmatic part of that forecast is that it’s deemed to be better, from a business perspective, to be wrong prognosticating rising yields than the opposite. Yields have a tendency to rise much more quickly than they fall, so there’s an asymmetry of risk in forecasting rising long-end yields vs. falling ones.
The prudent course then is to anticipate that yields will rise, because there is less time to respond to rising yields than falling yields. However, this is the exact opposite of the risk asymmetry for monetary policy that Fed Governor Lael Brainard discussed yesterday.
In Brainard’s opinion, the principal risk of raising rates now is that it is too preemptive, and that doing so could cause the unintended and undesired consequence of a deceleration in economic potential, which would (logically) result in falling long-end yields.
The reason for the opposing views of the risk asymmetry posed by a Fed rate hike, and its effect on economic activity, and thus long-end yields, is determined by which end of the economy you think is most instructive of immediate future economic potential.
There’s been an increasing coalescence around the idea that declining unemployment rates and tightening labor conditions are symptomatic of imminent inflationary concerns that warrant higher short-end rates, and then would require higher long-end rates. However, that only comports with an economic environment where aggregate economic growth is already being evidenced — and that’s not the case, as Brainard stated, just as she did last December before the Fed implemented a rate hike.
Long-end yields rose in the few months prior to last December’s rate hike, but almost as soon as the hike was announced they began to decline again and maintained that trajectory throughout 2016, with intermittent pops as Fed members discussed the “need” to increase rates.
The decline in long-end yields since the last hike was not caused by the hike, though. It was caused by the markets realizing that the economic need for it did not materialize in economic activity. That also means that whether or not the Fed hiked last December, long-end yields, logically, would have followed the same path of decline.
Until something like fiscal stimulus forces aggregate economic activity to increase, macroeconomic forces will continue to put downward pressure on long-end Treasury yields, regardless of what the Fed does, and actually increase that downward pressure if the Fed hikes rates in this environment.