This was meant to be the year that the lengthy bond bull market finally turned into a full-blown bear market. And for much of the year, markets followed the script. Concerns about rising inflation and the Federal Reserve’s gradual retreat from monetary stimulus saw bond yields rise steadily (and thus prices fall). Yet market jitters throughout the year have, in the past six weeks or so, metamorphosed into full-blown fear of a pending slowdown or even recession, sending bond yields down sharply. And the latest decision on interest rates from the Fed provided no comfort to markets – indeed, it supplied the impetus for the latest sell-off.
Demise of the Greenspan put
Jerome Powell took over from Janet Yellen as chairman of the Fed on 5 February this year. That same day, the S&P 500 fell by 4% – the worst one-day hit the US market had taken since 2011. Although the US market recovered to hit new highs later in the year, it was a clear sign of what was already troubling investors – what would happen as monetary policy moved from being ultra-loose to a gradual tightening?
Powell took over as the Fed was starting to reverse quantitative easing (printing money to buy government bonds). But that couldn’t remain the case for good. And it fell to Powell to oversee the start of the reversal of quantitative easing (QE) – or as it’s become known, quantitative tightening (QT). Put simply, QE adds money to the market. The central bank prints cash and buys (mostly, although not exclusively) government bonds. In turn, the people who would have bought those bonds, or who owned those bonds, buy other assets instead.
QT is the opposite. The Fed takes cash out of the market by shrinking the quantity of government bonds it holds. When a bond matures and the Fed receives the cash, it simply destroys it rather than reinvesting the money in a fresh bond. The Fed is currently destroying around $50bn a month in this way, and in its final interest-rate setting meeting of the year last week, Powell confirmed that it plans to continue at that pace all through next year.
This in turn is what has rattled markets. While investors had expected the Fed to raise interest rates (which it did, by 0.25 percentage points to a range of 2.25% to 2.5%), they had also hoped for a “dovish” message, given the recent slide in the stock market. Yet, while officials indicated there would be two rather than three interest rate hikes next year, the overall message was nowhere near as soothing as investors had hoped. Hence the “flight to safety” rally enjoyed by US Treasuries.
So what next? As the chart above shows, ten-year yields are still significantly higher than at the start of 2018. And given Donald Trump’s tax cuts mean the US government will run a huge deficit next year – about 4.7% of GDP – which in turn means more government borrowing and a much larger supply of US Treasuries for investors to soak up, it would be logical to expect yields to rise in 2019. However, if fears of recession or over-tightening by the Fed grow, the appeal of so-called “risk-free” Treasuries may prevail.