Bond investors bet on lower highest interest rates

This is because with each passing month the world has drawn closer to the day when investors think the Federal Reserve will raise its benchmark federal-funds rate from its current level to near zero.

This in itself should raise Treasury yields – especially on short- and medium-term bonds with maturities of around two to seven years. Those yields represent, at least theoretically, the average expected federal-funds rate over the life of each bond, plus some additional compensation for the risk that those expectations are incorrect.

Sure enough, the yield on the seven-year Treasury note has risen to 1.353% this year from Wednesday’s 0.643%. But that’s still too low, given that investors now expect the Fed to raise rates in just six months. The general implication from bond yields is that the Fed will not eventually raise rates to around 1.5% to 2%, according to analysts.

By comparison, Fed officials have indicated they believe the fed-funds rate, the rate at which banks can lend each other additional reserves overnight, will reach 2.5% in the long run. -The so-called terminal rate reached in 2018 at the end of the last cycle of the central bank rate increases.

At one level, this is welcomed by investors, as it implies they can buy riskier assets such as stocks and corporate bonds on the assumption that interest rates will remain very low for the foreseeable future. At the same time, it suggests there are weaknesses in the economy that will make it harder for the Fed to tighten financial conditions without causing a recession.

Right now, many investors think the low implied terminal rate is simply because the Fed “wants to slack off for some reason,” said Priya Mishra, head of global rates strategy at TD Securities in New York. “I would argue that if the terminal rate is here because long-term growth is weak, it’s really bad for riskier assets.”

Ms. Misra and other analysts say there are some key reasons why bond investors may be pessimistic about the economic outlook.

One possibility is that the pandemic may have caused long-term damage to the economy, such as reducing the share of people willing to participate in the labor market.

Another is that high inflation, due to supply-chain problems, may prompt the Fed to raise interest rates sooner than it would have liked otherwise, thus preventing the labor market from fully recovering. Is. Backing this explanation: Market-based gauges of the Fed’s terminal rate have fallen since the spring as inflation has risen and investors have priced earlier rate hikes.

Some analysts have warned that a variety of forces could distort bond-market signals, such as Treasury demand from foreign investors facing lower bond yields in their domestic markets.

Whatever is suppressing yields, many see the risk of a major sell-off if inflation continues to warm and the Fed signals it may raise rates higher than investors expect. This in turn can spread to other markets as investors face higher long-term interest rates due to the sale.

Jim Vogel, interest rate strategist at FHN Financial, said the bond market has reason to expect a revaluation of long-term interest rate assumptions. But that may not happen next year, he said, as investors and the Fed are likely to focus on more pressing questions, such as when the central bank will end its bond-buying program and announce its first rate hike. .

“Since the Fed still basically fights the fires, everyone is going to see them drive in bright red trucks,” he said. “They won’t think about rebuilding the building.”

This story has been published without modification to the text from a wire agency feed