Bond Yields Still in the Driving Seat
Since the 2008 Global Financial Crisis, yields had hovered around zero for over a decade, for most developed countries. This, in addition with comprehensive global quantitative easing, drove many asset classes significantly higher. When markets have been driven almost purely by cheap money, leverage and excessive risk-taking, what happens when yield rise?
Let’s concentrate on the 10y US Treasury yield to start. The 2020 Covid-driven low at around 50bps marked a multi-decade turning point. Supply chain issues were further compounded by the Russia-Ukraine war, and inflation was sent soaring across the globe. Central banks – including the Federal Reserve – had no option but to turn hawkish. They tapered their bond purchases and embarked on a hiking cycle.
The Fed tightened by as much as 75bps at a time, a move that was almost unprecedented. Equity markets were understandably spooked by rates and yields rising, with the S&P500 index registering a 20% drop from its January 2022 highs.
The 10y UST yield peaked at around 3.50% in mid-2022, but then it retraced lower as markets tried to anticipate a coming recession due to the Fed’s hiking. The recession technically arrived in Q2 2022, with two consecutive negative GDP quarters registered. At the time of writing (early August 2022), the Fed Funds is at 2.50% and the 10y UST yield is hovering around 2.75%. The September FOMC meeting is pricing just above a 50bps hike and another 50bps is priced by March 2023. We then move to cuts priced in for the second half of 2023.
US Inflation, as calculated by the YoY CPI number, is running over 9% and it’s not showing any signs of reversal yet. Fed chair Jerome Powell has repeatedly stated that their goal is to bring down inflation, and many other Fed members have followed a hawkish rhetoric, in line with the chairman. So, the question we need to ask ourselves is: will the much-discussed Fed “Pivot” come as quickly as the markets are expecting?
The 10y UST yield is at a crossroads, with a high likelihood of a big move coming up next.
The 38.2% Fibonacci retracement held, and the break below the 2.70% support could be a false breakdown – a very bullish development if it holds. If that materializes, then we are likely on our way to test the upside of the descending channel. From that point, price movement will depend on the Fed September meeting and beyond. If inflation fails to drop, then Powell and his crew will have no choice but to keep the pedal to the metal and hike aggressively. Such action could squeeze yields higher and potentially head towards a new and final high between 3.5% and 4%. Under such a scenario, it wouldn’t be unrealistic to see the S&P500 index trade close to the pre-Covid highs at around 3300-3400 points.
Alternatively, a Fed “Pivot” would confirm the head and shoulders formation (see chart below). This scenario would take the 10y yield to 2% and possibly below, while sending risk assets to much higher levels.
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