Why didn't investors foresee the huge rise in bond yields?

Why didn't investors foresee the huge rise in bond yields? I believe it's because they made three key errors in evaluating U.S. inflation and Fed policy since mid-2021.

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The Federal Reserve's decision to tighten monetary policy has had a negative impact on bond returns, with the Bloomberg Aggregate index on pace for its worst year on record. The main reason is that Treasury yields have risen substantially as the Fed has accelerated the pace of interest rate hikes. This has made bonds a less attractive investment, and has led to disappointing returns for many investors.

The yield curve has been steadily rising throughout the year, and is now inverted. This means that the yield on the two-year maturity is above 4% while the yield on longer-dated instruments is below 3.7%. The increase in yields, coupled with the widening of spreads for corporate bonds, has caused bond prices for treasuries and corporates to fall significantly.

The yield on the 10-year U.S. Treasury note rose to its highest level in more than four years on Wednesday, as investor demand for safe haven assets continued to wane.

Yield CurveBloomberg
The yield curve is an important tool that economists use to understand the health of the economy.

It's looking like 2022 is shaping up to be a tough year for the markets. Bond returns are currently on track to be the worst in US history, according to calculations by Edward McQuarrie, emeritus professor of business at Santa Clara University. This is bad news for investors, and could lead to a rocky few months ahead.

It is surprising that bond investors did not foresee the sharp rise in yields that has occurred in recent months. This raises the question of whether they are properly positioned to weather the current market conditions.

It's clear that the Fed made some major missteps in their assessment of inflation and interest rates over the past year. As a result, we've seen a lot of economic instability and uncertainty.

In my opinion, the initial mistake was to believe that inflation was temporary. Investors viewed it as being tied to Covid supply-chain disruptions, but did not factor in how strong demand was. I wrote a Forbes article in July of 2021 titled "Solving The Puzzle of Falling Bond Yields: Why It Matters," and concluded that with economic output now approaching its pre-pandemic level, wage and price pressures are likely to build if economic growth exceeds the economy's potential rate.

The Fed's decision to raise interest rates in March came as a surprise to many investors, who had been expecting rates to stay low for the foreseeable future. However, the Fed's actions suggest that they believe the economy is strong enough to handle higher rates. This could mean good news for the stock market and the overall economy in the months and years to come.

I find it hard to believe that investors think a small increase in interest rates will be enough to curb inflation when the economy is growing so quickly. We are approaching full employment, and yet inflationary pressures continue to mount. It seems to me that we need to take more aggressive action to get inflation under control.

The Fed's third mistake occurred around the Jackson Hole meeting in late August. Even though the Fed had stepped up the pace of policy tightening at the May and June FOMC meetings, raising the funds rate by 75 basis points at each meeting, investors clung to hopes that it would pivot away from tightening aggressively. The main reasons were the global economy had weakened and prices for commodities including crude oil, gasoline and raw materials had softened.

It is disappointing that the Federal Reserve appears unwilling to support the economy if it weakens, as this could lead to further problems down the line. Additionally, it is concerning that inflation is picking up, as this could lead to further interest rate increases.

Looking ahead, the key issue for investors is whether additional policy tightening will spawn a U.S. recession. While it is difficult to predict the future, it is important for investors to keep a close eye on this potential risk.

The Fed's economic projections in September suggest that it is a close call. The forecasts are for flat growth of 0.2% this year and 1.2% next year. However, the more important issue for policymakers is how high the unemployment rate needs to rise to bring inflation under control. The Fed's projections suggest that the economy is not growing as quickly as they would like. Inflation is a major concern for policymakers, and they are closely watching the unemployment rate.

It is encouraging to see that Fed officials are optimistic about the unemployment rate only rising marginally in the coming years. According to the latest FOMC projections, the unemployment rate is expected to peak at 4.4% in 2024. This is a positive sign for the economy, as it indicates that the labor market is expected to continue improving in the coming years. Additionally, the Fed's preferred measure of inflation, the Personal Consumption Expenditure (PCE) deflator, is expected to fall from 5.4% this year to 2.8% next year and 2.3% in 2024. This is good news for consumers, as it means that prices are expected to stabilize in the coming years.

The recent stock market rally is a sign that investors are becoming more optimistic about the economy, despite concerns about rising interest rates. The decline in 10-year bond yields to 3.65% reflects worries that the global economy is headed for a recession, but the market rally indicates that investors believe the Fed will not have to raise rates aggressively.

I believe that talk of a Fed pivot is premature, as inflation is likely to stay above the Fed's 2 percent target for some time to come. The risk of recession is greatest in Europe due to Russia's squeeze on natural gas, whereas the United States is energy self-sufficient and the world's largest exporter of LNG.

While a recession next year is not ideal, it is not likely to be severe. This is because there are no major sectoral imbalances and financial institutions have strong balance sheets. If the Fed does pause, Treasuries will rally, but there is limited scope for Fed easing.