The Bond Market Takes Its Turn at Center Stage

As we previewed in January, the key financial story of 2022 was always going to unfold in the bond market. As expected, the Federal Reserve raised their Fed Funds rate last week for the first time since December of 2018 by 25 basis points. More importantly, they signaled more increases are on the way. Consequently, the US-10 Year Treasury yield rose 80 basis points, from 1.52% to 2.32%. 

Additionally, the Baa-spread to US-10 Year Treasuries rose from the very low 1.85% to 2.14%. This spread captures the amount the lowest tier of investment grade corporate borrowers have to pay over US Treasuries. The figure remains well below the 25-year average of 2.50%.

What really spooked Jerome Powell in March of 2020 was not the stock market falling, but the bond market seizing up. As you can see in the graph above, the Baa spiked to over 4% as Covid spread to the United States. So far, at a reading below historical averages, the market is giving the Federal Reserve the green light to continue raising rates.

Mortgage rates, which fell consistently from 1980 until the Covid low of 2.67% in 2020 have now risen sharply to 4.16%. If the US-10 Year Treasury yield reaches 3% the mortgage rate will rise to 4.75%. While this would still be a very reasonable mortgage rate given most of US history, it would be on the high side since 2020, and nearly double the bottom from 2020. 

While the Fed’s increase of 25 basis points was incredibly mild, Fed Chairman Jay Powell has made considerable effort since then to talk up the Fed’s commitment to raising rates. As of now, the market expects the Fed to raise at the next six meetings at the same quarter point pace. Although, the market is far from unanimous in their expectations. 

In 2018, when the Fed began raising rates, the market assigned almost 0% probability to the Fed reversing course and cutting rates. Which is in fact precisely what they did after a stock market correction of 20% and some vociferous complaining from then President Donald Trump. 

The tone in the White House in regards to rates has noticeably changed. President Joe Biden publicly asked the Fed to get inflation in check. With Jay Powell and Joe Biden aligned, the market expects the Fed Funds rate to gradually rise to 2.75%-to-3.00% by February of 2023. With a consistent slope of the yield curve, that would put the 10-year US Treasury at about 5%. And bring the 30-year mortgage rate to approximately 6.6%. 

There are a lot of wildcards and jokers in the deck that could change the Fed's course before they arrive at that destination. The inflation genie is out of the bottle. Russia's invasion of Ukraine is ongoing. Commodity prices remain elevated. Supply chains remain impaired. Covid is dormant, but not gone. China’s real estate sector is finally feeling the impacts of prolonged over-investment.

In the meantime, the Federal Reserve remains a key actor to keep an eye on. As former Fed Governor Thomas Hoenig presciently warned: when you try and unwind a decade’s worth of easy money policies, that all market participants have become very accustomed too, the outcomes are unknowable. The action has just begun to unfold.