The Bond Bears are Waking Up from Their Deep Slumber

By:  Steven L. Yamshon, Ph.D., Managing Principal

The Federal Reserve (the “Fed”) bank knows that there is too much liquidity in the system but has mixed feelings about reducing it. My sense is that the Fed will need to see that the following five factors are in place before they do anything:

  • An unemployment rate in the neighborhood of 3.8%;
  • Prime-age (25-54) labor force participation close to its pre-pandemic level;
  • Accelerating wage growth;
  • Long-dated inflation expectations at or above target levels; and
  • Non-transitory inflation at or above target levels.

All of the above factors have been accelerating, which leads me to believe that the Federal Reserve will start to first taper excess liquidity, and then begin to raise interest rates by the end of 2022.

If the Fed liftoff occurs as planned and unforeseen circumstances do not occur, we expect the 10-year Treasury bond to level off around 2% to 2.25%. To us, the message is clear, in an environment of rising interest rates, new buyers of bonds need to keep their duration shorter than benchmark duration. If the Federal Open Market Committee (“FOMC”) follows through with increases in interest rates, monetary policy will not become extremely tight until 2024. It is too soon to guess about the pace of tapering and the rise in interest rates, but the big move in financial markets will likely occur when interest rates rise above the equilibrium rate. We are not there yet.

If monetary policy will not be restrictive for approximately three years, we believe it is too premature to shift to a defensive position, especially if investors share our view that risk assets should perform well over the next 12-months.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.