Bonds May Be In For A Rude Awakening

Bonds May Be In For A Rude Awakening
Reda Farran, CFA

3 months ago2 mins

Sentiment can change fast in the bond market. Less than two months ago, the 10-year Treasury yield hit 5% for the first time in 16 years after investors dumped bonds en masse, sending their prices lower and forcing their yields higher. The rout, which threatened to put Treasuries on course for an unprecedented third year of losses, had been going on for weeks. It was fueled by two things: expectations that the Federal Reserve (the Fed) would keep interest rates at their current high levels for longer and that the US government would have to sell even more bonds to cover its widening budget shortfall.

But growing signs that the economy and inflation are both slowing have fueled expectations that the Fed might be done hiking interest rates, sending investors back into the bond market. In fact, the Bloomberg US Aggregate Bond Index – a benchmark that tracks the performance of a wide range of US investment-grade bonds – just notched its best month in nearly 40 years after rising 4.5% in November. The surge pushed the 10-year Treasury yield 0.6 percentage points lower during the month, to 4.33%. This yield is often considered “the risk-free rate” and is used to compare all other investments, so its decline led to a powerful rally in every other asset class, from stocks to crypto.

The key question now is whether this rally might stick around. Traders are betting that the Fed will cut interest rates by about 1.25 percentage points next year, with the first swing of the knife expected in May. And that might seem like a clear path for lower yields and an extended bond market rally. But Fed officials have warned – repeatedly – that it’s way too soon to start thinking about slashing interest rates: they need to see inflation back on target first. So if rates do stay higher, as they say, and all those traders become disappointed, you’ll want to brace yourself for a new selloff and a big move higher in Treasury yields. After all, traders have been burned before and bond market sentiment can change in the blink of an eye.

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