When yields/rates have risen as much as we’ve seen so far in 2022, and especially when the 10yr hit the 2.40% target that we didn’t expect to see quite so soon, and even more importantly when a sell-off keeps adding additional days to its resume without significant reprieve, the odds of a significant reprieve continue to increase. The late February recovery was the only potential example so far this year, but it was “artificial” (driven by safe-haven buying due to the Ukraine war).
Since then, yields have skyrocketed despite a few seemingly decent days. In setting the bar for “significance,” we can consider a combination of time and magnitude. In other words, if a rally is extremely large over a few days or if there are more than 5 days with moderate gains, we could read more significance into that.
At the same time, we need to be careful not to read too much into the sort of temporary consolidation that we’ve seen no fewer than 8 times since the Fed’s initial hawkish shift in late September, 2021. The chart below shows the periodic head fakes during that time. I didn’t highlight anything from mid-October through the end of November as that was a more legitimate opportunity (but ultimately only due to omicron’s effect on bonds heading into early Dec). The onset of the Ukraine war is also disregarded even though it was arguably not a great example of a legitimate opportunity to change rate strategy based on technicals and momentum.
Speaking of the onset of the Ukraine war, that is also at the center of an interesting observation about inflation and rates over the past month. To be sure, inflation expectations are critically important to the rate spike, both due to Fed policy implications and the basic reaction function for bond traders. The following chart began its life this morning as a potential source of hope for bonds by showing the deceleration in both 5 and 10yr inflation breakevens (aka “market-based inflation expectations” derived from the spread between nominal yields and TIPS yields).
But if we are going to draw a connection between inflation expectations and rates, then we need to account for the weird lack of response in late Feb and early March. In fact, rates were still falling even as inflation expectations spiked. Fortunately, this is something we’ve discussed multiple times over the past month and it’s as simple as this: in the early stages of the war, the safe haven demand for US Treasuries and other low risk assets outweighed the negative implications from inflation. Bonds were also waiting to see how the Fed would reconcile geopolitical risk versus inflation.
What’s the takeaway? I wouldn’t take away too much just yet. We still need to wait for more evidence that bond traders are satisfied with the extent to which yields have priced in inflation and Fed rate hike expectations. We can nonetheless hold out a shred of hope that we’re seeing early signs of that via TIPS breakevens (assuming they maintain this asymptotic approach pattern to long-term ceilings.