Fed taper: Why are bond yields moving down?

Bond markets are not jittery. Despite Federal Reserve’s aggressive stance, where it guided three rate hikes and swift ending of quantitative easing in March 2022, the long term 10-year bond yield along with short term two-year yield fell, rather than inching up.

Usually, any hint of monetary tightening translates into rising yields but the counterintuitive move of bond yields - 10-year from 1.47% to 1.42% and 2-year from 0.66% to 0.62% - had left many market participants confused.

Bond yields or interest rates are a reflection of economic health and inflation expectations. The interest rates in the developed world are at their nadir and they are at their lowest in the entire financial history of mankind indicating that growth has been weaker in these countries.

Market is not very optimistic on long-term growth, thus long-term bond yields came down amid central banks' hawkish stance, opined Mahendra Kumar Jajoo, chief investment officer-fixed income at Mirae Asset Investment Managers (India) Pvt. Ltd.

Long-term rates reflect long-term inflationary expectation, and if the 10-year yield is not spiking then it indicates that market is neither expecting higher inflation nor rise in real growth, he says. Historically, 10-year yield spikes up before Fed starts tightening monetary policy, and therefore 10-year yields have gone up from 0.5% to 1.5% in the last one year, he further adds.

Anand Nevatia, senior fund manager, Trust Mutual Fund, believes the market had already anticipated quick ending of quantitative easing so news was baked-in which negated any knee-jerk reaction on upside of yield movement.

Why are central banks raising rates amid feeble growth?

Despite the weak real growth in advanced nations, central banks are on the cusp of rate tightening due to raging inflation in these nations. The Consumer Price Index (CPI) in the U.S. is 6.8%, the highest in 40 years. In Germany too, one of the economies that is most sensitive to inflation, the current CPI of 5.2% is the highest in 40 years. The CPI of 5% in the U.K. is the highest in last ten years.

To fight inflation, yesterday the Bank of England (BoE) surprisingly moved up rates by 0.15%. Earlier this week, the International Monetary Fund (IMF) had issued a terse recommendation to the Bank of England to act against inflation. Rate hike by BoE would soon propel other central banks, like European Central Bank (ECB) and Federal Reserve (Fed) to raise rates, says Vijay Bhambwani, Head of Equity Research, Behavioural Technical Analysis, Equitymaster.

“Bad news always comes in piecemeal and BoE rate hike will force others to hike rates due to cash carry trade consideration,” he added.

In carry trade, investors borrow money in low interest countries and invest money in high yielding nations. Thus, to mitigate any outflow of funds from the U.S. (low interest) to England (high interest rate), the Fed and ECB would be forced to raise rates in future.

Impact on global equity markets

Going by past experience of 2018, when Fed reversed its monetary policy by hiking rates, risk assets like equities were dumped by investors. The same could happen this year too as real global economic growth is feeble. Broadest global stock index MSCI All Country World has recorded a strong gain of 15% in dollar terms since the beginning of the year on back of ample liquidity provided by quantitative easing programmes of the Fed and ECB.

But now Fed is ending its quantitative easing programme. With rising interest rates on the backdrop of low economic growth, any further upside in equities is difficult. When the Fed hiked rates in 2018 global market corrected sharply and the correction ended with a pause in rates by the U.S. central bank. Then, ECB and Bank of Japan (BoJ) were forced to carry on loose monetary policy to keep the equity market buoyant. The global equity markets are waiting with bated breath for ECB and BoJ policy meets that are slated this month. How many interest rates are coming down the pike will decide the future course of global equity markets in 2022.