Short-term bonds are having a terrible month

February 2023 has been a rotten month for short-dated government debt. The two-year Treasury yield started the month near 4.10 per cent and climbed toward 4.60 per cent after January's consumer price index came in at a stubborn 6.4 per cent. Thirty-year yields barely moved, which pushed the inversion of the 2-year/10-year curve to its deepest since 1981. Investors who began the year expecting a gentle glide path for the economy have taken a painful hit on duration.

How the cut trade was built

The sell-off at the front end comes from traders finally giving up on their view of where rates will peak. For months, short-term swap markets had been priced for rate cuts soon after the Fed stopped raising.

That view had respectable foundations. Headline inflation fell from 9.1 per cent in June to 6.5 per cent in December, goods prices were dropping and the Fed had slowed its increases from three-quarters of a point to half a point in December and then a quarter on 1 February. Many investors reasoned that a central bank slowing down would soon stop, and that one which stopped with inflation falling would soon cut. Markets priced exactly that, and bought two-year notes to profit from it.

Two-year notes take the beating

Strong January payrolls and upward CPI revisions, along with resilient retail spending, destroyed that trade. Dealers had to price both a higher peak, with expectations now past 5.25 per cent, and the loss of any easing in the second half of the year.

January's inflation report sealed it. Prices rose 0.5 per cent in the month alone, and core inflation, which excludes food and energy, stayed well above the pace the Fed can live with. After the annual revisions published on 10 February had already shown that the late-2022 slowdown was weaker than first reported, the January figures confirmed that inflation's descent has stalled.

Short-term notes get almost all their value from the path of policy rates over a 24-month horizon, so the repricing inflicted fast, heavy losses on portfolios positioned for cuts. Two-year notes, usually treated as a near substitute for cash, swung about like an equity index.

Lessons from 1994

The closest precedent is the bond rout of 1994, when the Fed began raising rates in February and doubled its target from 3 per cent to 6 per cent within a year. Investors positioned for stable rates were caught out, losses spread through leveraged portfolios, and Orange County in California filed for bankruptcy in December after its investment fund's bets on low rates went wrong. That episode showed how a repricing of the front end can reveal leverage that nobody knew was there. Its happier lesson is that the economy avoided recession, which is the outcome the optimists are still hoping for.

What the long end is saying

Long-term yields have stayed put because the bond market expects this tightening cycle to end badly, and optimism has little to do with it.

With front-end rates pushed to 4.60 per cent, the market is betting that the Fed will need a sharp downturn to tame inflation, and that expectation holds long-term growth assumptions down. An inversion this deep says, in effect, that investors expect short-term rates to be much lower in a few years than they are today. Rates fall that far only if the Fed is cutting in response to weakness, which is why inverted curves have preceded most American recessions of the past half-century. The curve cannot say when the downturn will arrive; in past cycles the lag between inversion and recession has ranged from months to about two years.

Winners, losers and the fragile parts

The winners are savers and money market funds, which can now earn yields on short-term bills that were unthinkable two years ago. The losers are anyone financed short and invested long. Banks that bought long-dated bonds when yields were near zero are sitting on large paper losses, which do not hurt their reported capital unless the securities have to be sold. Leveraged investors who borrow at short-term rates to hold higher-yielding assets now find the carry shrinking or negative.

That is where something tends to give. In September and October last year, Britain's gilt market came close to seizing up when pension funds using liability-driven investment strategies faced collateral calls after a sharp rise in yields, and the Bank of England had to step in with emergency bond purchases. No one had flagged that corner of the market as dangerous beforehand. The same pattern, of hidden leverage exposed by a fast move in rates, is what makes the current rise at the front end worrying.

The soft-landing reply

The counterargument is that long yields are low because investors expect inflation to fall back, not because they expect disaster. On that view the Fed can hold rates high for a while, the economy slows without shrinking, and the curve uninverts as inflation drops. The labour market's strength supports that reading, since households with jobs keep spending. But the Fed has rarely managed a soft landing after raising rates this far this fast, and the upside surprises of recent weeks make it less likely, since each one pushes the peak rate higher.

The next tests arrive quickly. The personal consumption expenditures price index, the Fed's preferred gauge, is due at the end of the month, February's jobs and inflation reports follow in March, and the Fed's meeting on 21 and 22 March will bring new projections. If those show policymakers pencilling in a peak above 5.25 per cent, the two-year yield has further to climb.

The rout in two-year notes has priced out the soft landing. With the front end locked into a hard tightening path, something in the financial system is likely to break before the year is out. The most likely candidates are institutions that borrowed short to lend or invest long, from regional lenders sitting on bond losses to leveraged funds, and the stress is likely to show first in funding markets rather than in the headline economic data.