A couple of weeks ago we wrote about Treasuries breaking new ground and the potential for them to go higher as higher inflation expectations gathered pace. Our main concern at the time was for the move happening quickly and it feeding into risk assets. Unfortunately this is exactly what has happened, with 10 year Treasuries first breaking the technical level of 1.20 then hitting 1.30, 1.40, 1.50 and even touching 1.60 very briefly overnight before settling in high 1.40s this morning. As we mentioned before we do think the move is justified given the very bullish economic outlook and the possibility of some inflation in 2022 and beyond.
When the source of market risk comes from rates, we often see a breakdown in normal market correlations and a sell off in risk assets, which is hard to comprehend given that it’s a bullish outlook that started the problem. These types of sell offs in risk can feel very uncomfortable and that is exactly what we are experiencing now. Some might say it’s a well needed pull back and the time to reflect on valuations, so maybe not unhealthy, but the correlation breakdown is unhealthy and the longer it goes on the worse it feels. The good news is that these breakdowns do not last long, but they can cause valuation damage while they persist.
So how long will this one last ? Obviously this is hard to predict, but it does feel like the severity of the rates move has been high and like everything in this cycle, extremely rapid. It is also unwanted by policy makers as once the rates move spreads into risk assets it becomes a highly unwanted tightening of financial conditions. Consequently we can expect more aggressive notes and speeches by central bankers in the coming days. From a market value perspective we now have Treasury yields almost bang on our year end targets of 1.50 and 2.30 respectively for 10s and 30s, but we know markets tend to overshoot when we have periods like this, so we would not be surprised to see more pain, but that could be temporary.
In terms of catalysts to calm markets, specifically rates markets as the source of this turmoil, we do have the FOMC meeting next week which will be another opportunity for Chairman Powell to be firmer in his tone and reel yields back. Then on Friday we have the monthly non farm payrolls data release which should be supportive of Powell’s likely remarks on the job scene, but it is worth noting that February’s data is likely to be weather impacted.
Our best guess therefore is that we probably have a bit more pain to come but the authorities will be doing their best to avert this move and we can expect action now. In our opinion, from a positioning standpoint given the fundamental backdrop, unless one can be very nimble it is often best to sweat these periods out - or if cash is available, consider using them as an opportunity.