Global Slowdown Ahead?
Yesterday's bond market sell-off was brutal; the US 30-year bond yield surged 18 basis points to close at 4.61%, even touching 4.68% intraday. The immediate reaction points to faster growth and potentially higher inflation as the culprits behind this spike in Treasury yields. But are bond markets taking an overly simplistic view of the likely consequences of Trump’s potential policies?
Consider the proposed tariffs: 60% on Chinese imports and 10% on all others. While this could theoretically spur a resurgence of "made in America," the reality may be far different — and may even benefit bond investors.
Building factories to replace imports takes years, not months. Additionally, retaliatory tariffs from trading partners are almost certain. The likely outcome? Global trade slows, and with it, global growth. This weaker economic outlook may well lead to a flattening of the US Treasury yield curve. Instead of boosting long-term interest rates, we could see the dual impact of slower Fed easing (due to a short-term inflation spike from tariffs) combined with weaker growth exerting downward pressure on yields.
Estimating the extent of this shift is challenging without exact policy details. However, our econometric models, developed three decades ago to understand bond market drivers, offer some insight. These models show that long-dated bonds respond primarily to growth expectations, while shorter maturities are more sensitive to short-term rate movements. While this is not surprising, it does allow us to estimate fair value for the curve.
Notably, today's Treasury yields appear to be above their equilibrium levels: 5-year yields at 4.26% should be closer to 3.95%, 10-year yields at 4.42% should be around 4.05%, and 30-year yields at 4.60% should be closer to 4.28%. These discrepancies suggest an overreaction in the market.
The Fed, likely to cut rates by 25bps today, remains focused on the jobs market, not just inflation. Tariff-induced inflation cannot be countered by monetary tightening, and the worst-case scenario is a slower pace of Fed easing, contingent on the extent of the growth slowdown.
So, rather than a sustained trend, the recent yield surge looks more like a temporary spike. As growth expectations moderate under the weight of trade headwinds and a slower Fed response, long-dated bonds, particularly the 30-year, could see yields revert closer to equilibrium. This suggests an opportunity for bond investors to consider adding duration, especially if growth weakens and the Fed adopts a more accommodative stance than currently anticipated.
In the short term, 5-year yields may remain volatile, driven by near-term inflation and the Fed’s response. As tariffs, inflation, and growth dynamics play out, like the Fed we will remain data-dependent, using our models to guide us. For now, the key takeaway is to avoid over interpreting recent yield movements as a new paradigm. This bond sell-off may, in fact, be a buying opportunity for investors willing to look beyond the current noise toward a more moderated economic outlook.
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