Weekly Brief: All It Took Was One Knock, And Bonds Have Come Tumbling Down

Weekly Brief: All It Took Was One Knock, And Bonds Have Come Tumbling Down

almost 2 years ago3 mins

The bond market was already looking precarious, but the Federal Reserve’s (The Fed’s) announcement this week that it would be raising interest rates faster than expected sent it crashing down.

🕰 Recap

  • The US Federal Reserve said this week that it was prepared to take more aggressive measures than expected to fight rising inflation
  • That set US government bonds on a course to post their biggest quarterly loss ever
  • But certain bond markets have already started pricing in the possibility that the Fed will be forced to do a U-turn next year

✍️ Connecting The Dots

The Federal Reserve has been watching price rises warily for a while now, but it’s been holding off from responding until it was sure the country’s economy could withstand any inflation-busting measures. And we seem to have reached that stage: the Fed said on Wednesday that it might raise interest rates by 0.5% next month – twice the typical uptick. Some investors are even speculating that it’ll do the same thing the following month, which isn’t out of the question: the Fed has indicated that it’s expecting the interest rate to reach 2% by the end of the year.

That combination of higher inflation and higher interest rates is the perfect cocktail for bonds to crash. And crash they did, with short-term US government bonds now well on the way to suffering their biggest quarterly loss on record. That stands to reason: higher inflation means bond investors will get less bang for their buck, given that the income they offer remains fixed even as the value of money erodes. Meanwhile, higher short-term interest rates make cash – perceived as safer than bonds – a lot more attractive, while forcing existing bonds to trade at a discount to higher-yielding new bonds.

But it’s not just government bonds under pressure: corporate bonds are having a rough time too. Higher rates will make it more difficult for companies to finance or refinance new projects and execute deals, and ultimately make it more likely they’ll default. But here’s the contradiction: the only way to fix the damage done by higher rates might be… higher rates. After all, it should eventually lead to a slowdown in economic growth and inflation, forcing the Fed to cut rates again and creating a more positive environment for bonds to outperform.

🥡 Takeaways

1. The house doesn’t always win.

The last time bonds saw a selloff like this was back in the first quarter of 1980. And what happened next could provide a clue as to where we go from here: the Fed’s decision to cut rates in the face of slowing growth put a floor on the bond selloff back then. In fact, short-term US government bonds posted their biggest-ever gain shortly afterward. So if you think the Fed will be too trigger-happy with its rate rises this time around, you could take a contrarian position: bet on 10-year or 20-year bonds, and profit if the central bank reverses course further down the line.

2. Get ready for some true-blue volatility.

It’s not just bonds: after years of market tranquility, we’re seeing outsized moves in almost every market. Still, it serves as a timely reminder about how important it is to have intelligent position sizing and a strong risk management system in place. So you’ll want to be extra cautious in this environment: expect the worst for every asset you trade, and be sure to keep some of your funds in cash. Oh, and avoid leverage, complex derivatives products, and illiquid assets. Better safe than sorry…

🎯 Also On Our Radar

The price of bitcoin finally breached $44,000 this week, and while on-chain activity is still looking quite bearish, there are encouraging signs for the future. It’s now broken out of its recent narrow trading range, suggesting it could finally be able to build some momentum. Consider too that Russia is flirting with the idea of accepting it as payment for its commodities, and things could be looking up for the OG cryptocurrency.



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