The past few months have seen an open war between investors and major Western central banks, including the US Federal Reserve (Fed) and the European Central Bank (ECB). The battleground is the bond market.
Like a grand political wrestling match, the momentous and palpable tension is evident in the struggle to demonstrate who is in charge.
In the red corner are the central bankers, now with the bit firmly between their teeth, aggressively and determinedly pushing interest rates higher to reverse runaway inflation.
They are battling with investors in the blue corner to try to dampen the enthusiasm of central banks, believing that interest rates that are too high could bring down the economy car.
Bond yields
Bond yields, a barometer of sentiment that anticipates the trajectory of future interest rates, experienced significant, almost brutal volatility. As a reminder: when the yield of a bond increases, the price falls; the reverse applies when yields fall.
To illustrate the large fluctuations, let’s take the example of the German 10-year government bond yield: with a negative yield almost all the time from May 2019 to March 4, 2022, on May 12 the yield reached +0.85 %. By mid-summer, it had doubled again to reach +1.78%; at the time of writing (August 1), it has more than halved, losing more than a percentage point, to +0.76%.
Interest rates are not precision instruments, rather they are blunt tools
Government bonds are meant to be havens of sanity and calm (or so regulators still believe). Such volatility is not supposed to happen!
Bond and equity markets are intertwined, especially those equity sectors referred to as “bond proxies” whose companies have strong cash flows, tend to be less sensitive to the economy and have l used to reliably pay dividends that increase over time.
Also referred to as “growth” sectors, their stocks began to rally in this phase of falling bond yields and rising prices.
Jupiter Merlin portfolios have one foot in both the “growth” style camps and the more economically sensitive “value” style camp to mitigate the risks of being locked in during such changes in style, which can be abrupt and pronounced.
The Fed and the ECB deploy the heavy artillery
The ECB announced its policy intentions at its June meeting but, instead of the quarter point it had expected, in July it unexpectedly rolled out a half point hike to bring the deposit rate back down. euro zone to zero, the first time since mid-2014 that the rate has not been negative.
Government bonds are meant to be havens of sanity and calm… such volatility is not meant to happen!
It was followed by the U.S. Fed raising interest rates by three-quarters of a point, exactly as expected, for the second month in a row, and the fourth rebound in interest rate hikes since March, when the The Fed’s latest rate hike cycle has begun.
Little reported, largely because in the grand scheme of things Canada is a minor player, earlier in July the Canadian central bank raised interest rates by a full point (Canada, New Zealand and Sweden started tightening monetary policy last year, months before their much larger cousins).
Does interest rate medicine work as a cure for inflation? Russian President Vladimir Putin is actively engaged in economic warfare with the West. Its main weapons are the supply of oil/gas to Europe and cereals.
To be clear, it does not control global inflation, but it exerts a malevolent influence on it.
That the economy is already technically in a recession to some extent misses the point
For policymakers, limiting the money supply, containing spending and curbing the rate of economic activity are the essential ingredients for controlling inflation. Interest rates are not precision instruments, rather they are blunt tools.
What is the evidence so far that US interest rates, pushed from zero to 2.5% in four months, are having an effect?
The US economy is slowing down
Second-quarter economic growth data released in July points to a demonstrable slowdown as real profits fail to keep pace with accelerating prices and consumers and businesses tighten their belts.
The U.S. economy shrank 0.9% in the period from the first quarter, after shrinking 1.6% from the fourth quarter of 2021.
Two consecutive quarters of economic decline is the popular definition of a technical recession.
However, (here it’s about choosing your data to suit your case) those who claim the economy is still in good shape and growing will point to comparisons with a year ago, which show that at second quarter growth was positive 1.6% year-on-year; in the first quarter, the annual growth rate was 3.5%.
That the economy is already technically in recession to some degree misses the point: whatever data is chosen, in both cases, the indicators point to economic momentum waning.
The concern is whether the Fed’s continued aggression is really pushing the US into an unequivocal recession. The bond market battle continues.
John Chatfeld-Roberts is Chief Investment Officer at Jupiter Asset Management
