Thanksgiving: Bond investors finally have something to be thankful for

The ten-year Treasury yield has fallen from its October peak of 5.02 per cent to about 4.40 per cent, handing bond funds large mark-to-market gains just in time for Thanksgiving. After one of the worst bear markets in modern financial history, fixed-income managers finally had something to be grateful for. The November rally in long bonds was remarkable.

From rout to rally

The bear market began in 2020, when the ten-year yield fell below 1 per cent in the panic of the pandemic. As inflation surged and the Federal Reserve raised its policy rate from near zero to a range of 5.25 to 5.50 per cent, long bonds lost value year after year. In 2022 Treasuries suffered their worst calendar-year loss in decades, and the longest-dated bonds had lost roughly half their value from the peak by October. For pension funds, insurers and holders of balanced portfolios, the traditional safe asset had become the source of losses.

Three reasons for the turn

Cooler inflation figures, smaller Treasury issuance plans and a growing belief that the Federal Reserve has finished raising rates all drove the reversal. At the start of November the Treasury increased its long-dated auctions by less than feared and suggested the increases were nearly over. The Fed held rates and said the rise in long yields had tightened conditions. The October jobs report was soft, and consumer prices were flat on the month, pulling annual inflation down to 3.2 per cent. Traders who had bet on higher yields rushed to close their positions, amplifying the move.

How gains spread

The mechanics of bond prices explain the size of the windfall. A bond's price moves inversely to its yield, and the effect is larger the longer the maturity, a sensitivity known as duration. A fall of more than half a percentage point in the ten-year yield lifts the price of a ten-year bond by several per cent; for a thirty-year bond the gain is much larger. Banks with large unrealised losses on their securities, insurers and pension funds all saw part of those losses recovered, easing pressure on balance sheets that had been strained since Silicon Valley Bank failed in March.

The benefits went beyond bond holders. Mortgage rates, which had approached 8 per cent in October, have dropped back as the ten-year yield fell, offering some relief to homebuyers. Stocks rallied strongly through the month, since lower yields raise the present value of future earnings. Companies seeking to refinance debt found investors more willing to lend.

The rally has spread abroad. Government bond yields in Europe and Britain have fallen alongside Treasuries, as inflation there has also eased faster than expected, and the dollar has weakened as investors expect the gap between American and foreign interest rates to narrow. A softer dollar and lower Treasury yields ease the strain on emerging-market borrowers who owe dollars, and on central banks that had been defending their currencies. Japan is a partial exception, since the Bank of Japan still holds its short-term rate below zero and the yen remains weak, though the fall in American yields has taken some pressure off it.

Too much of a good thing

The rally may undo itself. Lower long-term borrowing costs and higher equity multiples have loosened financial conditions a great deal. If conditions ease too far, they could revive the very demand the Fed is trying to cool.

This is the paradox that bond investors face. In October, the rise in yields was doing some of the Fed's work for it, and officials said as much. The rally has undone much of that tightening in a matter of weeks. Minutes of the Fed's most recent meeting, published this week, showed officials intending to keep policy restrictive for some time and ready to tighten further if progress on inflation stalled.

A lesson from 2022

The market has been here before. In the summer of 2022 investors convinced themselves that the Fed would soon pivot towards cuts, and bonds and stocks rallied through July and early August. Financial conditions loosened markedly. At the Jackson Hole conference in late August, Jerome Powell delivered a short, blunt speech warning that the Fed would keep policy tight until the job was done, and the rally collapsed. The episode showed that the Fed pays close attention to conditions and will push back when markets run ahead of it.

The case for a lasting turn

The counterargument is that this time the fundamentals support the rally. Inflation has fallen far more than it had in mid-2022, the labour market is softening, and the Treasury has eased its supply plans. If core inflation keeps slowing and unemployment keeps edging up, the Fed may accept lower yields as consistent with its goals, and the rally could hold. Many forecasters now expect rate cuts next year.

That may prove right, but it depends on data the market has not yet seen. The indicators to watch are November's inflation and jobs figures, due in early December, and the Fed's projections at its meeting in mid-December, which will show whether officials share the market's expectation of cuts.

Bond investors should enjoy the turkey while it lasts. By loosening financial conditions so quickly, the November rally makes it more likely that the Fed keeps policy tight well into next year, which would push yields back up, and a hawkish message at the December meeting is the most likely trigger.