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Signs global bond markets could bottom after central bank rate hikes
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Fixed income investors are experiencing what could be the toughest year for bond markets in 45 years, with 2022 shaping up to be the worst since 1931.
Bonds are units of debt issued by companies or governments that are converted into marketable assets. They contain the terms of the loan, such as the interest payment, the principal of the bond and the maturity date. Bonds essentially function as instruments used by governments and corporations to borrow money. Although the stock market generates far more headlines, global bond markets are much more valuable than equity markets, with more than $100 trillion tied up in bonds worldwide versus $64 trillion in stocks.
Investors generally demand higher interest rates for loans to governments over long periods, reflecting the opportunity cost of tying up their money longer amid rising growth and inflation expectations. On the other hand, short-term rates sometimes rise above longer-term yields, disrupting the usual bond market trend. When the yield curve inverts, investors demand more interest to lend to the government for shorter periods. This anomaly implies that investors are anticipating an upcoming drop in economic growth. Historically, an inverted yield curve has been a strong indicator of an impending recession. This is especially true when the United States faces strong global headwinds from Europe, where the Russian-Ukrainian war and related sanctions have created a painful shock to energy prices.
Many consider bonds to be safer alternatives to other investments, and Treasury bonds are among the safest government bonds. Although bonds are less volatile and tend to outperform equities in tough economic times, that doesn’t mean they’re a solid investment or that you should only invest in bonds.
Olive Invest has gathered bond market information from various professional, expert and news sources to paint a clearer picture of the performance of the US bond market.
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Interest rates continue to rise, but at a slower pace
Federal Reserve Bank of the United States Building
Two years into the worst pandemic in a century, the global economy is still grappling with the lingering effects of the COVID-19 pandemic on diminishing economic growth and soaring prices. Specifically, the United States has been battling inflation since the economy rebounded from COVID-19-related industry shutdowns and supply chain disruptions. To curb inflation, the Federal Reserve has taken advantage of the tools at its disposal, mainly interest rate hikes and the threat of news. More recently, the Fed raised interest rates by 75 basis points. However, the pass-through effect in the bond market could cause bond prices to fall.
At first glance, the relationship between interest rates and bond prices may not be obvious. But upon closer examination, it becomes clear that when central banks raise interest rates, bond prices fall, ensuring that the face value of the bond remains constant. This is known among future brokers studying for their securities licensing exams as the seesaw, comparing bond prices and interest rates to a seesaw on a children’s playground. Due to the inverse relationship between interest rates and bond prices, further declines in bond prices can be expected as the Fed continues to raise interest rates.
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Stock market volatility, driven in part by European risks, is pushing investors to seek safe havens like Treasuries
United States Savings Bonds with American Currency
Ideally, equity markets offer higher expected returns than fixed income markets. However, they also carry higher risks of loss. Aggressive Fed rate hikes and emerging market bond default risks combined with energy crisis-related factory furloughs in Germany and other European manufacturers to spook investors. The result was a flight to safety, with institutional and individual investors turning to Treasuries.
Falling bond prices have begun to present lucrative opportunities for investors looking for yield but safety. Short-term instruments currently offer rising yields at 4.48% over six months, 4.53% over one year and 4.41% over two years, while longer maturities like five- and 10-year bonds offer yields of 4.18% and 4.01%, respectively. .
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Recession rhetoric from business and political leaders drives stocks lower, likely pushing bonds higher
Stock market chart and dollar bill
As the Fed maintains its hawkish stance and Fed Chairman Jerome Powell signals it will continue to raise rates aggressively, industry pundits and investors fear this could push the U.S. economy into the recession.
The last time the Fed raised rates aggressively to curb inflation was in the early 1980s under then-Fed Chairman Paul Volcker. Fed Volcker rate hikes made borrowing and mortgage rates so expensive that bank certificates of deposit insured by the Federal Deposit Insurance Corporation fetched 18% in May 1981, near the height of the severe 1981-82 recession. .
As for the current outlook, Fed officials have said they want to keep raising interest rates well above the current range of 3% to 3.25%, leaving analysts to speculate up to how high rates could rise. However, the costs of servicing the global debt that governments have accumulated over the past 40 years in G7 countries, including the United States, would make any Fed rate hikes approaching the interest rates at which Americans witnessed in the early 1980s.
Interest rates rising faster than expected, the unforeseen effects of quantitative tightening and the expected protracted war in Ukraine are indicators that analysts say risk tipping the US economy into recession. Against this challenging global backdrop, industry experts such as JPMorgan Chase CEO Jamie Dimon believe the S&P 500 could suffer a painful downturn. A negative outlook for equity markets could in turn draw investors back to fixed income markets, which would drive bond prices higher.
This story originally appeared on Olive Invest and was produced and
distributed in partnership with Stacker Studio.
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