Edward Harrison is the founder of the blog Credit Writedowns and is a finance specialist at Global Macro Advisors. Previously, Edward was a strategy and finance executive at Deutsche Bank, Bain, and Yahoo. He started his career as a diplomat and speaks German, Dutch, Swedish, Spanish and French. Edward holds an MBA from Columbia University and a BA in Economics from Dartmouth College.
2018 has started with a lot of angst about bond yields. And there is some cause to be concerned. But this owes to an economy that is growing more briskly and to the Fed that has been and probably will be more hawkish than you think.
When thinking about people trying to shoehorn a China explanation into what’s happening, let’s remember that the rise in US yields isn’t a new thing. It’s been ongoing since the beginning of September. Look at the chart for two-year yields; it’s a straight line up since September.
What changed? Bond markets recognized that the Fed was serious about hiking rates irrespective of inflation below target.
Let’s back up for a second. If you go back to early last year, St. Louis Fed President Bullard was saying that he felt some tightening had to happen via balance sheet reduction instead of rate hikes because he was concerned the Fed could tighten too quickly, flattening the yield curve and choking off the recovery. The Fed, mindful of this, laid out a balance sheet reduction program and even refrained from raising rates between June and December even though the pace of economic growth had begun accelerating and the Fed had brightened its economic outlook at the June meeting. The trough in yields came on September 8th, with the 2-year at 1.26%.That’s when the markets got religion about the Fed’s raising rates.
What I was saying then was that we are at an inflection point. Three years before, the Fed had begun tightening as all the other central banks were still easing. By September 2017, it was clear that the Fed would soon be joined in tightening by other central banks. And that would cause the market to recognize the Fed was serious about tightening more, something that favoured long maturity Treasuries.
What’s more is that, at that time, we were still treading water in the 2%ish economic growth realm. As long as rates remained low, investors had to reach for yield by adding duration or risk. So while yields went up because of the recognition of the Fed’s desire to continue to tighten, initially rates went up most at the shorter end and the curve flattened.
Fast forward to today and robust economic growth is now taken for granted. We are in a synchronized global economic upturn and economists are saying there is scant chance of a recession in the next 12 months. What we would expect to see in this environment is a continued push upward in rates as the market moves toward the Fed. And we should also expect a mild steepening of the curve in early 2018 to boot.
Bottom line: The Fed is telling us its intent is to stick to its projected three rate hikes in 2018. The economic data have been good enough to support the Fed’s policy guidance. And the bond market is begrudgingly moving to the Fed’s position rather than the other way around.