By Veronica Fulton, Research Analyst – GLOBALT Investments.

The market is forward-looking, and the yield curve represents all investor expectations on where interest rates should go, both now and in the future. So, what does a narrowing spread between 10-year and 2-year treasuries suggest? The bond market is concerned about both inflation (short-end) and economic growth (long-end).

Inflation

The 7.5% year-over-year growth in the CPI reading does not appear to be solely attributed to COVID induced supply-chain issues. Data continues to show extended trends in rising rents and wages that may not subside quickly. As a result, it is becoming increasingly difficult to label inflation as “transitory.” By keeping rates low for such an extended amount of time, central banks all over the world have let inflation run amok and must stomp on the brakes as opposed to easing off the gas to combat rising prices. Now bond investors are bringing forward their rate hike expectations and front-running monetary policy, resulting in a flatter yield curve – a phenomenon that almost always occurs before the Fed raises rates.

Economic Growth

If the Fed raises rates too much, they could cause structural underpinnings to falter – mainly elevated levels of global government and corporate debt that have been manageable due to ultra-low rates. If the Fed raises rates too quickly, they run the risk of halting the expansion of a rebounding economy dependent on high levels of liquidity. Consequently, the bond market appears to suggest it isn’t sure the Fed can raise rates without dampening the economy – hence the longer end of the curve remaining low. The change in 5-year rates dwarfs changes in 30-year rates. If the trend continues and short-term rates rise above the longer-term ones, we will have an inverted yield curve and the bond market would theoretically be forecasting an impending recession – we’re not there. Nonetheless, if Fed policy is seen as potentially becoming too restrictive, the market would begin factoring in a higher probability of a slowdown.

Both equity and bond investors who’ve grown accustomed to seeing asset prices increase unabated through eras of easy money may have a tougher road ahead. Higher rates reduce the present value of companies’ future cash flows. Slowing economic activity as a byproduct would dampen corporate revenues and earnings. It should come as no shock that broad market indices such as the Russell 3000 and S&P 500 are down year to date. This is normally the point where investors could increase allocation to bonds to offset losses. But with inflation pressuring already negative real rates even lower and the Barclays US Aggregate Bond Index down -4.18% at the time of this writing, bonds don’t appear the be the trade either. In a nutshell, higher rates are bad for stocks and high inflation is bad for almost all asset classes – namely bonds. If current market conditions persist, investors will have to heed the bond market’s warning and execute more tactical allocation strategies to combat inflation and generate real returns.

Sources: FactSet, Piper Sandler


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