BofA's warning of '5% world' sinks as returns soar

(Bloomberg) — Around the world, bond traders are finally beginning to realize that the rock bottom yields of recent history may be gone forever.

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A surprisingly resilient US economy, ballooning deb

The recent sell-off has hit long-term bonds even further, and has wiped out the broader Treasury market’s gains this year, putting it on track for a third straight annual loss. It also dragged down stock prices, which had risen strongly until this month amid expectations about the Fed’s path.

The latest turn is likely to be off base, and some forecasters on Wall Street are still calling for an economic downturn that should put downward pressure on consumer prices.

Moreover, inflation expectations have held firm this year as the pace slowed sharply from last year’s highs, a sign that the market expects it to eventually ease closer to the Fed’s 2% target. The personal consumption expenditures index, the Fed’s preferred measure of inflation, rose at a 3% pace in June. This is down from as much as 7% in the previous year.

What Bloomberg Strategists Say…

The neutral short-term real rate that underpins the US economy will reach 2.5% by the end of this year, according to researchers at the Federal Reserve Bank of New York. Given that PCE inflation averaged 3.7% in the second quarter, the Fed may have to tighten its policy benchmark to at least 6%.”

– Ven Ram, Macro Strategist, MarketsLife

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But many now expect a soft decline that will leave inflation as the dominant risk. This was underscored this week by the release of the minutes of the FOMC meeting from July, when officials expressed concern that more rate hikes may still be needed. They also noted that the Fed may continue to reduce its bond holdings even as they decide to ease interest rates to make policy less restrictive, threatening to keep another drag in the bond market.

That helped push Treasury yields higher this week, with the benchmark 10-year Treasury yield rising to 4.33%. That’s close to the October peak, which was the highest since 2007. The 30-year return was 4.42%, a 12-year high. The yield trimmed the jump on Friday.

Broader economic shifts are driving speculation that low rates – and inflation – in the post-crisis period were anomalies. Among them: demographics that may raise wages as elderly workers retire; away from globalization. And it leads to counter the global warning to turn away from fossil fuels.

“If inflation is going to be flat and high, I don’t want to own long-term bonds,” said Kathryn Kaminsky, chief research strategist and portfolio manager at AlphaSimplex Group.

“People are going to need more term premiums to own long-term bonds,” she said, referring to the higher payments investors typically demand at the risk of parting with their money for a longer period.

Even with the recent hike in yields, though, it’s no longer such a premium. In fact, it remains negative as long-term rates remain lower than short-term – an inversion of the yield curve that is usually seen as a harbinger of recession. But that gap is starting to narrow, which has lowered the New York Fed’s measure of term insurance premiums to about negative 0.56% from nearly 1% in mid-July.

This upward pressure has also been exacerbated by US federal spending, which has led to an influx of new debt sales to bridge deficits even as the economy remains at – or near – full employment. At the same time, the Bank of Japan’s decision to finally allow 10-year yields there to rise is likely to dampen Japanese demand for US Treasuries.

BlackRock’s Boivin says a major shift is underway in the world’s central banks. He said that for years they have kept interest rates well below the rate considered neutral to stimulate their economies and stave off deflationary risks.

He said, “Now that has been reversed.” “So even if the long-term neutral rate does not change, central banks will maintain a policy above that neutral rate to ward off inflationary pressures.”

(Updates to add Yardeni tout.)