By Han Tan, Chief Market Analyst at Exinity Group
Bonds are extending their slump worldwide, driven by fears that central banks have to get more aggressive in quelling red-hot inflation.
Earlier this week, Fed Chair Jerome Powell left the door open for a larger-than-usual 50-basis point hike at the FOMC meeting in May, with other Fed officials also adding their voices to this ultra-hawkish chorus this week.
Fed Funds futures are now pricing in seven rate hikes at the FOMC’s six remaining meetings for the rest of 2022, suggesting a larger 50-basis point hike could take place soon.
Shorter-dated debt is especially bearing the brunt of the Federal Reserve’s more hawkish stance, with the year-to-date surge on 2-year Treasury yields now rising to 145 basis points. This would make for the worst quarter since 1984.
Yields on 10-year Treasuries have also hit the psychologically important 2.40% level for the first time since 2019, as the spread between the 2-year and 10-year has whittled down to a mere 20 basis points or so, its flattest since the onset of the pandemic in 2020.
Battling inflation
Despite war still raging in the Ukraine, major central banks apparently are of the view that the main economic risks stemming from the military conflict are inflationary rather than a demand or sentiment shock.
Policymakers at the Fed have made it clear that subduing inflation is their top priority and may be willing to risk a hard economic landing in order to achieve that goal.
More outflows from fixed-income assets can be expected as markets continue front-loading Fed interest rate hikes, while also pricing in the ramped-up prospects of a US recession occurring next year.
The selloff in bonds also suggests that investors are on the hunt for necessary hedges, not just against multi-decade high inflation, but also the prospects of a steeper tightening cycle.
Stocks unfazed by bond rout
On the other hand, equities are performing as if all is well with the world.
Asian stocks are in the green, while US and European futures are also adding to recent gains, with the S&P 500 halving its year-to-date losses on the back of its recent rally.
It’s tough to find a watertight explanation for such risk-on behaviour in light of looming threats, with the still-raging war between Russia and Ukraine compounding the risks of an ultra-hawkish Fed.
Bond outflows are perhaps finding their way into equities, but the two asset classes are sending out different messages.
While bond investors are blaring on the recession foghorns, stocks appear more receptive to the Fed’s rosier outlook, with the central bank insisting that the US economy is strong enough to withstand higher interest rates.
The stock bulls’ narrative assumes that companies have enough pricing power to pass on higher costs to enough customers with enough jobs, thus preserving profit margins, at least for 2022. One cannot also rule out the TINA (“there is no alternative”) mantra having its say on fund allocations for the time being.
Still, it may require further positive justification in order to sustain the advance in stocks.
More overt signs of stagflation in the months ahead could present a major moment of reckoning for equity bulls, with any shocking realisations potentially in turn unwinding gains in equities.
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