The recent stresses in the financial system have caused a tectonic shift in the market sentiment of fixed-income investors. No longer is there as much hope of avoiding a significant economic downturn, nor is inflation considered the most dismaying issue.
Officials in the U.S. Treasury Department and Canada’s Ministry of Finance are assuring us that all is well. Central bankers, for their part, are dropping few hints they may be poised to cut interest rates any time soon.
But the people who actually trade bonds – the folks with their skin and their clients’ money in the game – have adopted a bleaker outlook. Bond market participants now are wagering that the U.S. Fed (as well as the Bank of Canada) will cut rates in the not-too-distant future in order to stave off an ever-worsening financial crisis precipitating a serious economic slump.
Who will be proven correct? History provides some guidance. But there are other things we need to keep in mind first.
The Federal Reserve and central bankers across the developed world have been raising short-term rates at a breathtaking pace for about a year. There’s a narrative in the bond market that central banks control yields over the very short term, while bond traders and portfolio managers assert their dominance over prices and yields to an increasing degree the longer the maturity of the instrument.
This became somewhat less true as quantitative easing – the massive bond purchase programs at central banks – was adopted as a policy tool during and after the 2008 financial crisis. But the basic narrative still holds.
A normal yield curve slopes upward, as yields rise over the longer term to reflect the increase in risk over longer periods. Yield curve inversions occur when the collective weight of the market believes that interest rates are headed down to below the level central bankers have set for very short-term rates.
Less than a month ago, we were seeing the most inverted yield curve in decades. That reflected the belief that the Federal Reserve remained on the path to raising short-term interest rates, which would slow the economy for longer. So short-term rates were rising while long-term bond yields declined in anticipation of easing inflation and slower economic growth.
Both central bankers and the bond market overall seemed to believe that inflation would eventually be curtailed without a serious recession. The Fed seemed determined to bring interest rates down to a more manageable 2 per cent. The market appeared to have a more sanguine view, suggesting that although inflation would be coming down from the double-digits of last year, it would likely stay well above 2 per cent.
The yield curve may have been forecasting a slowing economy, but the stock market, unemployment rates and the spread between corporate and government bonds were pointing to continued – albeit unspectacular – growth, or at worst a mild technical recession. In essence, inflation was seen as a bigger concern than recession.
This all changed dramatically in the very short period between March 8 and March 13 as we entered our first real banking crisis since the 2008 downturn. Some banks that could not be more different essentially collapsed: Silicon Valley Bank, Signature Bank and Credit Suisse. Central bankers and government finance officials assured an anxious public that the situation was not dire.
However, the bond market was flashing greater concern.
On March 8, two-year U.S. Treasuries and three-month T-bills both hovered around 5 per cent. Investors, in aggregate, were signalling that interest rates would be effectively unchanged two years from now.
By March 13, three-month yields declined from 5.01 per cent to 4.79 per cent, less than a quarter of a percentage point. Two-year yields, by comparison, declined by 108 basis points to 3.99 per cent, in one of the most expeditious declines that traders can remember. (A basis point is 1/100th of a percentage point.)
If investors believed that the Fed was going to begin cutting rates drastically in the near term, then selling short-term T-bills and buying two-year bonds would be the smart trade. That seems to be what happened in mid-March. Demand for two-year bonds was so strong it pushed the yield – which moves inversely to price – down sharply.
Investors who could still buy T-bills just below 5 per cent immediately gave up the belief that in three months they could buy two-year bonds at the same approximate rate.
The collective view of the market changed to believing that the Fed would cut rates, and significantly: perhaps by between one and 1.5 percentage points in as little as three months.
In the meantime, the yield curve has become less inverted. Because inverted yield curves often foreshadow a recession, one might think this a positive signal for the economy. But that would be a false conclusion.
The yield curve tends to normalize even before a recession occurs. It’s also possible the Fed may be too slow to cut because of legitimate inflation concerns, which won’t be good news at all for the economy.
Perhaps the market is overreacting to developments. What traders are pricing into the bond curve is constantly changing, too. This week, bond yields have risen sharply and implied probabilities in swaps markets suggested only about 50 basis points of interest rate cuts by the Federal Reserve and Bank of Canada by year’s end.
But what’s clear is the market thinks central bank interest rate hikes are over, and the next move will be to cut rates.
Although the future is uncertain, the market tends to be right especially in times like this. In every downturn we have experienced since the 1960s, government officials assured us things would be fine – and then they were not. I do not believe that their losing streak will end in 2023.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed-income and asset-mix strategy. He is a former lead manager of Royal Bank’s main bond fund.