Behind the move: deep skepticism among many investors that the Federal Reserve will raise short-term interest rates as high as they did in the last economic expansion—a level that was itself the lowest peak for rates over the past seven decades.
Fed Chairman Jerome Powell sent shudders through markets last week when he didn’t rule out relatively aggressive steps to help bring down inflation, such as rate increases at consecutive meetings or a half-a-percentage-point increase at a single meeting.
Bond investors, though, have responded by lifting their expectations for the speed of rate increases, not the total number. The yield on the benchmark 10-year U.S. Treasury note, which loosely reflects expectations for short-term rates over the next decade, settled Tuesday at 1.799%—still up from 1.496% at the end of December but down from 1.866% on Jan. 18 and 1.806% just before Mr. Powell’s news conference on Jan. 26. Yields move in the opposite direction of bond prices.
Investors pay close attention to longer-term Treasury yields because they help set borrowing costs across the economy and are a key input in stock valuation models. Many cited their early-year jump as a major factor behind recent stock declines and a rout in speculative wagers such as unprofitable tech companies and cryptocurrencies. Rising bond yields can exert an especially large drag on so-called growth stocks because investors deem uncertain future profits less valuable when they can get more guaranteed income from Treasurys.
The recent stabilization in yields has coincided with a rebound in stocks, with the tech-heavy Nasdaq Composite Index rising 7.4% over the past three sessions.
Bond investors aren’t ignoring the Fed. Officials’ shifting tone on inflation helped push yields higher in January, as investors adjusted to the possibility officials could raise rates at least four times this year. A sizable cohort of investors still think short-term rates could reach at least as high as they did a few years ago, when the central bank’s benchmark rate briefly topped 2.25%.
Still, rising yields also face obstacles, including from investors who have been surprised by the Fed’s shift.
Such investors still generally think that inflation could subside largely on its own this year as supply-chain problems get sorted out and consumer demand fades along with the effects of fiscal stimulus. The same investors have seized on a recent stretch of weaker economic data, seeing evidence of a normalizing economy rather than just a temporary setback caused by the latest surge in Covid-19 cases.
“I do not think there’s enough convincing evidence right now of a post-pandemic world that’s much different than it was pre-pandemic,” said John Bellows, a fixed-income portfolio manager at Western Asset. “If we get into ‘23 and ‘24 and growth is substantially higher and so is inflation then the market price could price that, but I think it’s too early right now.”
Complicating matters for investors, even economists who have been urging the Fed to take inflation more seriously say that it is highly uncertain how sensitive the economy will be to rising rates.
Before the 2008-2009 financial crisis, many economists believed that the appropriate level for inflation-adjusted interest rates was about 2% over the longer run. After the crisis, economists gradually lowered their estimate of the so-called neutral rate—citing various factors that may have increased household savings or slowed business investment—as inflation remained muted despite rates that remained near zero.
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Financial markets responded accordingly, with investors piling into bonds and repricing stocks based on the declining yields. That gave a special boost to companies valued mostly on their future potential earnings, such as fast-growing technology companies.
As it stands, most Fed officials have indicated that they think rates should eventually settle at around 0.5% in real terms, or 2.5% in nominal terms assuming inflation settles at their 2% target. Still, Mr. Powell has cautioned that these are educated guesses.
Some economists have warned that investors are underestimating how high rates can go. William Dudley, who was New York Fed president from 2009 to 2018, has argued that short-term rates could easily get to 3% or 4% in the coming years. Assuming inflation remains above 2%, he noted in an interview that the central bank would have to raise nominal rates above 2.5% just to get to a 0.5% real rate. It could then have to go further to actually slow the economy.
Leah Traub, a portfolio manager at Lord Abbett who is expecting higher Treasury yields, said investors don’t need to know exactly how high rates will get as long as they believe they will move higher than bond prices are currently reflecting.
Whether real rates settle at “0.5, 1 percent or even zero, we are very far away, so we need to tighten, and that’s the direction that I’m going to be positioned for,” she said.
Write to Sam Goldfarb at [email protected]
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