What the return of bondholders means for investors


The annual central bankers’ conclave in Jackson Hole, Wyoming, is usually of interest only to market watchers and the savviest economists who appreciate the micro-analysis of the carefully scripted wording of speeches and press releases. But this year was different.

After raising interest rates this year by 2.25% to a target range of 2.25% to 2.5%, the Federal Reserve, the US central bank, needed to “pivot” to a more dovish stance. This could mean that the 0.5% increase in September would be the last, or that the increase would be 0.25%, or that there would be no increase at all.

Instead, Jerome Powell, Chairman of the Federal Reserve, reiterated the need to reduce inflation by raising interest rates whether or not that causes economic hardship for households and businesses.

Why the Fed changed its mind on interest rates

What caused this apparent change of heart?

Not the inflation rate, which rose from 9.1% in June to 8.5% in July while the core underlying rate fell to 5.9%. Inflation is expected to decline further in August and economic indicators point to a further decline in the coming months.

Instead, Powell appears to have reacted to the bond market. The yield on ten-year US Treasuries rose from 1.5% at the start of the year to a peak of 3.5% in mid-June before falling back to 2.6% at the end of July. Since then, it has climbed back to 3.1%, indicating that while bond yields can accept the current downward trend in inflation, they are not confident that it will fall back to 2% and stay there.

The spread between inflation-protected bonds and conventional bonds, considered a good indicator of inflation expectations over the next ten years, fell from 2.3% to 2.6%, putting the credibility of the Fed. The Federal Reserve, it now seems, has embarked on a monetary policy that will satisfy the bond market.

“Bondwatchers,” a term coined by economist and market analyst Ed Yardeni in the 1980s to describe a world in which bond investors drive monetary policy, are back.

Of note, the 24% drop in the S&P 500 between the start of the year and mid-June, a period during which corporate earnings continued to grow at a healthy pace, coincided almost exactly with rising bond yields. So did the 17% rally through mid-August, as well as the subsequent 8% drop.

Stock investors aren’t particularly concerned about the effect a recession would have on corporate earnings, as they know that corporate earnings will pick up along with the economy. They are much more concerned about the risk of higher bond yields, which translate into lower interest rates.

If bond investors are happy, stock investors are happy

This flies in the face of conventional wisdom that claims recessions are “bad” for stock markets, so markets will be undermined by higher rates. Investors want central banks to do whatever it takes to bring inflation down, regardless of the short-term economic consequences. If bond investors are happy, so will stock investors, and the yield on 10-year US Treasuries is the best indicator of investor confidence.

Consumers and businesses don’t like paying higher interest rates on their loans, but they like inflation even less. They don’t want a recession with its risk of unemployment and lower living standards, but will likely accept short-term sacrifices if the result is lower inflation and lower interest rates, combined with a return to longer-term growth. We are all inflation vigilantes now.

The reason US inflation is down – and therefore the economy is in good shape – is because of energy. Fracking has made the United States self-sufficient in oil and gas, on top of that the United States is bordered by two friendly hydrocarbon-rich nations. Europe, by contrast, has entrusted its future energy needs to Russia, succumbing to anti-nuclear superstition and a Russian-backed campaign against fracking. There are few signs of policy change.

Britain falls somewhere in the middle with many hydrocarbon reserves, but an aversion to exploiting them.

The UK seems determined to make the problem worse. The Bank of England was slow to raise interest rates, so the pound fell 5% in August alone. This promises to exacerbate inflation and worsen the outlook for the UK economy.

The government has the fiscal leeway to mitigate the recession, but all the media and popular pressure is aimed at short-term solutions that make the problems worse.

The imperative is to reduce the demand for hydrocarbons and increase the supply, not to finance short-term grants through loans and taxes on production. We will soon see if the new government will be able to meet the challenge.

The world follows where the United States leads

Ed Yardeni notes that the falls in US GDP in the first two quarters meet the definition of a recession, but he expects the data to be revised higher, helped by the strength in employment. He doesn’t ‘expect a downturn over the rest of this year and/or next to be severe enough to qualify as an official recession’, but instead sees the continuation of a ‘continuing recession’. crossing different sectors and regions.

As a result, he expects “S&P 500 earnings growth of -5.4% and -3.8% year-over-year in the third and fourth quarters”, which still means growth of 3.1% for the whole year and 9.3% next year.

That puts the S&P 500 at 18.4 times earnings this year and 16.9 times next. Whether it’s cheap or expensive depends a lot on the Federal Reserve dancing to the beat of bond vigilantes. If so, US Treasuries might even have a reasonable value.

The United States accounts for 62% of the global stock market, while Japan, where inflation is just 2.5%, is also in good shape. Countries facing serious economic difficulties, including the UK, EU and China, make up less than 20% of the index. As the United States goes, global markets will follow.


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