Short and Sharp: the bond market’s ir/rational response

Bond markets can sometimes come across as irrational, and the last few weeks may be a perfect demonstration of this. Three weeks ago, 10-year U.S. Treasury yields declined in response to the U.S. Federal Reserve’s (Fed) projection that policy rates would be raised several more times over the next 18 months and the Fed’s signals that they’ll soon begin reducing the size of their balance sheet. This slightly unusual reaction reflected the bond market’s fear that the Fed’s tightening path would harm U.S. growth prospects. Then, last week, it took just a few hawkish words from the European Central Bank (ECB) and the Bank of England to trigger a sharp bond market sell-off… on both sides of the Atlantic.

Which reaction was the “rational” one?

If I had to pick, I would say that the second reaction – the sell-off – was the more rational. After many years of near-zero policy rates and balance-sheet expansion, I believe that the global economy is strong enough to withstand a removal of monetary policy stimulus. Inflationary pressures are confusingly subdued but, with labor markets so tight, I buy into the Fed’s thesis that it is just a matter of time before upward price pressures emerge. Therefore, raising rates is no policy error.

And so, all it took was a few unexceptional words from ECB President Draghi (“deflationary forces have been replaced by reflationary ones”), and from Bank of England Governor Carney (“some removal of monetary stimulus is likely to become necessary if the economy remains firm”) to trigger a bond market sell-off in Europe, which then rapidly spread to the United States and around the globe.

Ten-year U.S. Treasury yields are back to where they were in mid-May. But, at 2.35% (as of Tuesday 4th July), I think they have higher to go.

At the start of this year, I filled out some investor surveys that required me to make a vague estimation of where 10-year U.S. Treasury yields would be by the end of 2017. I ticked the 2.5%-to-3% box, as did the majority of respondents.

While we economists love the option of a wide range, in this case I’m willing to narrow it down to 2.5%-to-2.75%. If I am right, the sell-off will continue, but we’re not facing a bond market rout. I strongly believe that monetary policy tightening will be slow – as per the Fed’s own policy rate forecast – and will be clearly sign-posted. That’s the reason I am quite sanguine about the bond market outlook.

As I described in The Federal Reserve’s Balance Sheet, during the “Taper Tantrum” in 2013, former Fed chairman Ben Bernanke caused major market disruption when he loosely announced the idea that quantitative easing would end in “the next few meetings.” Yet when the Fed’s strategy was stated more clearly – explaining that asset purchases would be reduced only gradually – there was minimal effect of the tapering. The same could be true of balance sheet reduction if communication is clear and transparent.

The Fed seems to get this. John C. Williams, president of the Federal Reserve Bank of San Francisco, said the Fed’s approach to normalizing monetary policy will be “the most telegraphed monetary policy of our lifetimes.” Admittedly, last week’s speech from ECB President Draghi perhaps didn’t meet that requirement. But it did serve as a good reminder to central bankers of the importance of careful communication, and I suspect they will choose their words more wisely in the coming months.

As long as my two conditions – gradual hikes and clear communication – are met, 10- year U.S. Treasury yields should remain below 3% this year and risk assets can continue to outperform. As yields rise, credit spreads should narrow – although I expect only a modest tightening in spreads given current tight valuations. Equity markets are vulnerable to further bond market sell-off. But at these bond yield levels, as long as investors do not consider central bank policy as an error, I believe equity markets can continue to do well.

Once again, monetary policy is set to dominate markets.



Follow Principal Global Investors on LinkedIn



Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of June 2017. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon to make an investment decision.

The information in this document contains general information only on investment matters. It does not take account of any investor’s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account.

Principal Financial Group, Inc., Its affiliates, and its officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document or in the information or data provided in this document.

Third party content, such as comments to this blog, is not reviewed by Principal Global Investors before it is displayed, although we may remove, alter, edit or adapt any such comments. Principal Global Investors does not endorse, authorize, or sponsor any third party content. Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided.

Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline.

Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.