Checkmate!. Bond markets have nowhere to escape… | by Sagar Singh Setia | Sep 2022
“Although higher interest rates, slower growth and less favorable labor market conditions will reduce inflation, they will also provide some pain to households and businesses. These are the unfortunate costs of reducing inflation. But failure to restore price stability would mean much greater pain.” – Jerome Powell, Fed Chairman, Jackson Hole 2022.
In the game of chess, the ultimate goal of the player is to propel his opponent into checkmate. Checkmate is the ultimate move where the player’s king is in check, and there is no escape or defense possible.
At Jackson Hole 2022, we saw a checkmate from the Fed, and bond markets were stunned to listen to Jerome Powell’s eight minutes of super warmongering.
Powell’s speech in Jackson Hole was stunning in every way. Quoting Paul Volcker and his lessons from the 1980s, Powell looks both worried and determined. I would like to draw your attention to the third lesson that Powell spoke about in his talk:
(emphasis added throughout by author)
“That brings me to the third lesson, which is that we have to persevere until the job is done. History shows that the wage costs of reducing inflation is likely to rise with a lag, as high inflation becomes more entrenched in wage and price setting. Volcker’s successful disinflation in the early 1980s followed several failed attempts to reduce inflation over the past 15 years. A long period of very restrictive monetary policy was ultimately needed to stem high inflation and begin the process of reducing inflation to the low and stable levels that were the norm until the spring of last year. Our goal is to avoid this outcome by acting decisively now.
The jury is out, and it doesn’t look good for the bond and stock markets. A “super-hawkish” Fed pledged to bring down inflation and, in doing so, induce difficulties in the economy. The most likely outcome will be a spike in the unemployment rate, which will slowly climb to 5-6%, further ensuring that demand destruction takes place and inflation returns to the comfort level of 2%.
After losing its credibility in the face of the “transitional” rhetoric of inflation, Powell now has the best opportunity to restore the credibility of the world’s largest central bank.
Today we’ll be talking about the bond markets, which are undoubtedly nervous after the Jackson Hole speech. Let’s understand what is happening in the world of bonds.
Bonds were hit the hardest after Jerome Powell’s “Volcker Avatar” hit at the Jackson Hole. Whereas the short part of the curve is experiencing a massive steepening, the long part is still 30 basis points from the highs reached in June.
The 2-year yield hit its highest level since the GFC and now stands at 3.8%. The significant tightening continues as other Fed officials continue to make ultra-hawkish statements.
Cleveland Federal Reserve Chair Loretta Mester said she sees the benchmark rate above 4% and no cuts until at least 2023! It is a slap in the face to the bond markets which are anticipating declines from mid-2023.
Bond markets are also forecasting a recession over the next 12-18 months, with yield curves inverted across the curve in the United States.
The 10Yr-2Yr has been inverted over the past two months and is the most inverted since the dot-com bubble, which also suggests that the market expects the future growth trajectory to be weak. Currently, it is hovering around -35 bps.
As the probability of 75 basis points increases to over 85% at the next FOMC meeting, it is expected that the 10-year could reach new highs and surpass previous highs of 3.5% reached in June.
Powell has also repeatedly said he wants to see positive real returns across the yield curve. To finish, the markets obliged him after his 8-minute speech on inflation in Jackson Hole.
Although today’s newsletter is all about bonds, don’t forget that positive real returns bode ill for risky assets.
Stock markets and gold prices tend to underperform when real returns are positive.
Exploring history, the only time we witnessed a bear market in bond markets was in 1980-1981, when Volcker unleashed his draconian avatar to control monstrous inflation.
The drawdown was 21%, and there is “no” other example of a bear market in the US bond, whether in investment grade or Treasuries.
Fast forward to 2022, and we are in the first bond bear market in generations. The Bloomberg Global Aggregate Index is down more than 20% since hitting record highs in January 2021.
The Bloomberg Global Aggregate Index is a leading measure of global investment-grade debt across twenty-four local currency markets.
It includes treasury bonds, government bonds, corporate bonds and securitized fixed rate bonds from issuers in both developed and emerging markets.
The 20% drop in the Bloomberg Global Aggregate Total Return Index (LEGATRUU) shows that tightening is a globally coordinated activity by central banks, the bond rout is prevalent around the world.
The gigantic rally that bonds around the world have witnessed after the GFC and NIRP (negative Interest Rate Policy) by CBs is unfolding, tormenting many wallets.
Remember, Powell said more pain was coming!
In the days of the equity rout, flight to safety usually occurs in bonds. As a result, 60:40 portfolios were designed [60% in equities and 40% in bonds] at cushion the impact of negative stock market returns.
However, the correlation of bonds with equities is approaching historic highs this year.
This resulted in the poor performance of the 60:40 portfolios. The era of stagflation in the 1970s and 1980s saw similar episodes of positive correlation.
As interest rates followed a downward trajectory after the start of the 21st century, were massive gains in the bond markets. The rolling 2-year correlation between the S&P 500 and the Bloomberg US Agg Bond Index was below 0 for most of the 20 years, indicating that bonds were an almost perfect hedge against equities.
Let’s look at the returns of the 60:40 portfolio over the years.
It is a remarkably intriguing picture. We can infer that when the S&P fell significantly in the same year, bonds generated positive returns. This helped investors limit the decline in their stock portfolio by buying “adequate protection” in the form of bonds.
However, 2022 has been an unusual year. Therefore, the 60:40 portfolio is off to one of the worst starts in its history and will most likely end the year with one of the worst returns on record.
The US economy has been extremely resilient; however lately some cracks have started to grow (housing). However, the labor market continues to surprise positively.
Until we see a significant slowdown in the U.S. economy, lower inflation, and a cooling of one of the hottest labor markets ever, The Fed will continue to tighten policy.
As the synchronized tightening gathers pace over the next two months, we could see the bond rout intensify over the next 2-3 months.
However, as bond markets expect, we could see some recovery in bond markets by the first half of 2023; if the Fed can get the scorching inflation under control, which is now entrenched in the system.