The acceleration in real rates is about to become a problem for risky assets
Senior Fixed Income Strategist, Saxo Bank Group
Summary: Demand for inflation linkers is falling as investors anticipate inflation expectations to adjust lower amid an aggressive Federal Reserve. Yet, if the Fed disappoints net week, TIPS might rebound briefly, supporting risky assets. However, inflation is likely to remain well above the Fed’s target in the long run. Thus, the central bank will need to keep hawkish for longer, making the rise in real rates inevitable.
While US Treasuries were benefitting from safe-haven demand yesterday, a ten-year TIPS auction showed that investors are unwilling to buy inflation protection at the current yield level. Ten-year TIPS sold with a yield of -0.54%, tailing by 2.6bps. The bid-to-cover was the lowest since July 2020, and indirect bidders were down to 59.3%, the lowest since May.
Investors are unwilling to take on inflation protection securities as the Federal Reserve becomes more aggressive and inflation expectations are adjusting lower. Today, the 10-year breakeven rate is recording the biggest drop since January last year, provoking an acceleration in real yields that are taking them close to test resistance at -0.5%.
Although risky assets show more resilience than instruments that carry high duration, we expect things to change as real rates break resistance at -0.5% and rise quickly to -0.35%. Indeed, by that time, 30-year TIPS yields would have already turned positive, indicating that financing conditions are tightening fast, threatening risky assets.
So far, duration has been a bigger villain than credit quality. Year to date, US Treasuries with 20+years maturity (TLT) have fallen -4.2%, investment grade USD bonds (LQD) dropped -3.4%, and emerging market hard currency bonds (EMB) -3.7%. At the same time, junk bonds that carry much shorter durations have proven more resilient, with junk in the US (HYG) falling -1.8% and Europe (IHYG) only -1.1%.
However, next week's FOMC meeting could support real rates if the Fed doesn't sound as hawkish as the market expects. So far, the market is pricing four interest rate hikes, with some market players expecting two rate hikes in the March meeting. Any indication of fewer hikes might produce a drop in nominal yields and a rise in breakeven rates, translating into lower real rates.
Latest Market Insights
Q4 Outlook 2022: Winter is coming
- Winter is coming to the financial markets as central banks are tightening their grip. How spring will look is still a question.
European energy crisis: it will get worse before it gets betterThe winter in Europe will be tough, but whether the result is political chaos or sustainable, innovative solutions is still undecided.
A difficult and volatile quarter awaitsAs the year draws to an end, commodities continue to be at centre stage of the world with growth pockets political uncertainty.
The bright side: crises drive innovationThe positive spin on crises is that they come with solutions. It is worrisome that deglobalisation may be a response to this crisis.
Green transformation in China: renewable energy and beyondGoing green, China needs to span numerous energy sources to ensure stability, as every source comes with a challenge.
Asia: Intermittent solutions, but a faster renewable adoption curveAsian energy supply is being squeezed. This and the adoption of renewables may change the investment sentiment in the region.
FX: A Fed thaw needed to deliver a sustained USD turn lowerThe US Dollar can keep momentum when the Federal Reserve continues to tighten, leaving the rest to play to their drum.
Autumn can become ugly for equities and bond holders. Comfort for Dollar longsTechnical analysis suggests that equities could face a tough Q4 as could fixed income. US Dollar positions could provide some upside.
The next stock market sector to watch, with stocks going nuclearAs the world scrambles to find affordable, sustainable energy, nuclear is getting attention from politicians and investors alike.
The crypto space is getting cold when the hype disappearsCryptocurrencies face a winter of their own as retail investors and governments are asking tough questions.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)