Are We in for a Bond-pocalypse or Something Much Milder?
Is last week’s 18 basis point selloff in 10 year government bonds the start of a bond bear market or a market adjusting to the realities of the time, albeit in a somewhat disorderly way? The answer to this question has obvious implications for not just bonds, but all asset classes from equities to commodities to real estate. After all, the cost of capital is like a magic number that informs the value of all financial assets. If long-term rates are set to explode higher a-la 1994, then bond and equity investors alike need to be careful.
When trying to understand the recent move in bonds, it’s helpful to measure the movement of each component of the bond: real growth expectations, break even inflation, and the term premium. The 18 basis point move was driven by the term premium rising by +18bps, a +1bps point rise in inflation expectations and a -1 basis point decrease in real growth expectations. That is, there was practically no alteration of either inflation expectations or growth expectations, and nearly the entire sell off was driven by the term premium.
What, then, does the term premium measure exactly? In our world of bloated central bank balance sheets, the term premium is both a reflection easy money policies as well as a measure of an unexpected growth or inflation shocks permeating the economy over the term of the bond. Therefore, last week’s selloff could be a caused by an expectation of a more normal Fed policy stance over the long-term and/or a reflection of something that materially changed causing investors to need more compensation for holding longer term treasuries. Included in major news items in the last week or so were a Fed meeting, some PMIs suggesting higher input prices, a decent employment report, and an escalation of the trade confrontation with China. Of these, only the first and fourth strike us as actual market moving news. So, explaining the move in term premiums may be the result of the bond market coming to terms with policy normalization with a bit of tariff fears mixed in. Since trade policy is so hard to discount, we’ll focus on Fed policy.