This week saw expectations of the US Federal Reserve hiking the rates aggressively in its battle against inflation reach a fresh high, which exacerbated the pressures on bonds and stocks alike.
Terminal rate expectations
The Fed is scheduled to hold a policy meeting on September 20-21st and investors are awaiting another super-sized hike in the interest rate.
Bets on an aggressive increase in the terminal rate have ramped up because of the inflation numbers that turned out to be hotter than expected and they now stand at 4.5%.
This put it more than 200 basis points higher than the current overnight interest rate. A month ago, the peak that had been projected had stood at about 3.7%.
Stocks do not respond positively to higher interest rates in the US. The stock market had enjoyed a rally over the summer, while there was a decline in bond yields that have an inverse relationship with prices.
This had been in hopes that the central bank may decide to slow down its pace of interest rate hikes. However, this week saw those hopes dashed because of the consumer price index (CPI) data.
It showed that inflation had climbed to 8.3% in August on an annual basis, which was higher than the 8.1% forecast from analysts.
According to market analysts, the US Fed is now expected to increase the interest rate by another 150 to 200 basis points, but the debate right now is the speed with which they will accomplish this.
Real yields have also gotten a boost because of the expectations of an even more hawkish Fed. This shows how much an investor can make annually with a US government bond.
Moreover, it also works in dulling the attractiveness of riskier assets when they climb. The 10-year TIPS (Treasury Inflation-Protected Securities) yields are known as real yields.
This is because they eliminate projected inflation. On Friday, these real yields rose by 1.03%, which is the highest they have been since January 2019.
There has been a 100 basis point increase in real yields since the start of August. There has been an increase of 8 basis points in 10-year government bond yields to 3.443%.
If they climb higher than 3.495%, which they had done in June, they could come close to a high of 11 years.
On Friday, Goldman Sachs also noted that these yields could actually go as high as 3.75% by the end of the year. Furthermore, things certainly don’t look good for corporate debt either.
Market analysts said that investors are no longer confident in the ability of the US central bank to be able to engineer a soft landing for the economy.
This is because the yield spread is also rising, as it was 450 basis points before the release of the CPI data, but it climbed to 480 basis points in this week alone.
This also increases the chances of an economic recession in the country in the next year or two.