The upward adjustment in bond yields was warranted and isn’t done yet, say the co-chief investment officers of hedge fund giant Bridgewater Associates.
Bob Prince, Greg Jensen and Karen Karniol-Tambour, in an article posted to the firm’s website, say the market is at an unusual stage where changes in economic conditions aren’t the biggest drivers of changes in yields and asset prices. “At this stage of the tightening cycle, what matters most will be whether the desired levels of conditions have been met; so far, they have not,” they say.
They said the market has re-priced higher-for-longer rates given inflation is still moderately too high, wage growth too high to allow inflation to settle into a target range, labor market conditions too strong to exert a downward pressure on wages and real growth not so weak as to justify an easing.
After an unusually strong retail sales report, the Atlanta Fed’s GDPNow estimate of growth for the third quarter was 5.4%. Consumer prices in September rose 3.7% year-over-year, the unemployment rate was 3.8%, and the employment cost index in the second quarter grew 4.5% year-on-year.
“Looking ahead, if the T-bill rate stays at 5% or higher, to get a risk premium in bonds you need a bond yield of 5.5% or higher. And given the coming supply of bonds and the withdrawal of central banks from buying them, demand will need to come from private sector investors, who will require a risk premium relative to cash,” says the Bridgewater team.
The 3-month Treasury bill
BX:TMUBMUSD03M
on Wednesday was yielding 5.5%, while the 10-year Treasury
BX:TMUBMUSD10Y
was yielding 4.85%.
U.S. government borrowing on the long end of the yield curve is about to rise to very high levels, “well in excess of the existing demand to buy bonds,” they add.
What will this new stage of the tightening cycle mean? They expect “grinding pressure on growth,” and for the equity market to become more uncompetitive relative to bonds.
The S&P 500
SPX
has gained 14% this year, though it’s down 5% from the highs of late July.
“Given grinding pressures on growth and restrictive policy that discourages an acceleration in credit, it is not likely that an acceleration in earnings will restore the competitiveness of equities relative to bonds, as earnings are more likely to be a contributing drag. Instead, restoring risk premiums in equities relative to bonds and bonds relative to cash likely requires higher yields and lower prices,” they say.
There is one exception: if the breakthrough in AI and large language models boosts productivity.
“The pricing can make more sense if we are on the verge of a substantial and sustained rise in productivity. The level of wages would imply a lower inflation rate. The discounted growth in earnings would make more sense. And a higher level of real interest rates could be sustained with less impact on the economy. Bond yields would still need to rise to provide a risk premium to the new equilibrium level of real short-term interest rates, but the economy and equities could more easily withstand those interest rate effects,” they say.
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