In this part of the US bond market, 0% is alarmingly high

(Bloomberg) — The U.S. bond market is hurtling toward the clearest sign yet that the Fed’s shift to aggressive gear is making a difference: a higher 10-year real interest rate. at 0%.

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While all Treasury yields have risen this year as the Fed began what is expected to be an aggressive series of rate hikes aimed at curbing high inflation, the last two weeks have seen the handover passed to protected notes and bonds. against inflation. Their returns are called “real” because they represent the rates that investors will accept as long as they are combined with additional payments to offset inflation.

For borrowers, whose income may rise with inflation, real interest rates represent a kind of real cost of money. For 10-year loans, it has been negative since early 2019, except briefly during the market chaos of March 2020. Ten-year real yields on inflation-protected Treasury bonds rose to -0.15% from -0.49% last week. The low point was -1.26% in November.

“Tighter Fed policy should fundamentally argue for higher real yields,” said Michael Cloherty, head of US rates strategy at UBS AG’s equity arm.

The era of negative real returns supported demand for riskier assets, easing financial conditions. To bring inflation back under control, the Fed needs to tighten through higher real yields. The pace may be faster this time. At the end of 2018, the 10-year real yield topped 1% after breaking out of negative territory in 2016 as the Fed slowly tightened policy.

Market expectations for how much the central bank will raise its policy rate have skyrocketed, with futures linked to Fed meeting dates now priced to peak at around 3.15% in mid-2023, compared to the current 0.25%-0.5%. Goldman Sachs Group Inc. Chief Economist Jan Hatzius said on Friday that it was possible to imagine circumstances in which it could exceed 4%.

“A real return above zero means that the valuations of stocks and all assets require reassessment,” said David Bianco, Americas chief investment officer for DWS. Fed officials “sound very convincing about fighting runaway inflation and are going to act.”

In the two weeks after Russia invaded Ukraine on February 23, triggering a surge in commodity prices that stoked demand for inflation-protected bonds, real yields briefly fell to last year’s lows. Yield gaps between regular and inflation-protected Treasury debt, which represents the amount of inflation needed to match their yields, widened, in some cases to the highest levels seen in two decades.

However, the subsequent rally in yields to the highest levels since before the pandemic has been led by real yields, a sign investors hope the Fed will succeed in reining in inflation.

The US consumer price index for March, to be released on Tuesday, is forecast to show a 1.2% monthly increase, larger than any since September 2005, bringing the annual rate to 8. 4%, last seen in 1982. .

Normally, a strong economy lifts real yields and inflation expectations simultaneously, but an aggressive Fed sets the stage for them to diverge, creating “extreme volatility in TIPS,” Cloherty said.

An index of Treasury inflation-protected securities has lost 3.3% since March 23 for a total return of -4.7% in 2022. While comparable regular Treasuries have fared even worse, with a year-to-date total return of minus 7.8%, they have outperformed in the recent period, losing just 2.4%.

The TIPS underperformance was deepened by revelations (first by Fed Governor Lael Brainard on Tuesday, then in Wednesday’s March Federal Open Market Committee meeting minutes) that the contraction in the balance would start earlier and develop faster than some markets. expected participants.

The minutes showed the Fed is poised to start reducing its balance sheet next month by not replacing all the maturing Treasuries and mortgage-backed securities it holds. The last time the Fed undertook so-called quantitative tightening, from 2017 to 2019, it set monthly limits on the amount of its maturing holdings that would not be replaced with new securities.

The minutes suggested the combined runoff cap could reach $95 billion within three months. While the cap was in line with bond traders’ expectations, the pace was faster than some had predicted.

As the Federal Reserve expanded its balance sheet from March 2020 to March 2020, TIPS fared better because central bank purchases of TIPS accounted for a larger share of the amount outstanding. The $256 billion increase in its TIPS holdings to $388 billion, more than a fifth of the market, outpaced market growth over the same period.

“The Fed became a major buyer of TIPS and now they don’t buy,” said George Goncalves, head of macro strategy at MUFG. “At the margin, QT is more important to TIPS than the broader Treasury market.”

Investors, meanwhile, who piled into the iShares TIPS Bond ETF last year, have been net redeemers this year.

Ruffer LLP, a manager of institutional investments of about $33 billion, recommends short-term TIPS for inflation protection, which have less price sensitivity than the broader market to rising yields.

“The Fed and retail are the buyers of TIPS and they are both pulling out,” said Alex Lennard, chief investment officer at Ruffer in London.

The recent resilience of US equities has helped bolster confidence that the Fed’s policy rate will hit 3.25%, and the potential implications for the dollar of the geopolitical realignments put in place by the The Ukraine crisis is leading investors into uncharted territory, said Glen Capelo, managing director of Mischler Financial.

“The Fed hasn’t tightened solely because of inflation since the early 1980s,” he said. “It’s the first time they’re really tightening while undoing QE at the same time.”

what to see

  • Economic calendar:

    • Apr 12: CPI, NFIB Small Business Optimism

    • April 13: MBA mortgage applications; IPP

    • Apr 14 – Jobless Claims, Business Inventories, Retail Sales, University of Michigan Sentiment and Inflation Expectations

  • federal calendar:

    • April 11 – Atlanta Fed President Raphael Bostic, Governor Michelle Bowman, Governor Christopher Waller, Chicago Fed President Charles Evans

    • April 12: Governor Brainard, Richmond Fed President Thomas Barkin

    • April 14 – Loretta Mester, president of the Cleveland Fed; Patrick Harker, President of the Philadelphia Fed

  • Auction schedule:

    • April 11: 13-week and 26-week letters, 3-year notes

    • April 12: 10-year notes

    • April 13: 30-year bonds

    • April 14: 4 and 8 week bills

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