Three questions for fixed income investors this week

What happened to bonds?

Nominal yields jumped on Wednesday with the 10-year U.S. Treasury yield touching 3.23%, a significant 14bp move in a 24-hour period. After retreating slightly, at time of writing yields have moved higher again reaching 3.24%, their highest level since February 2011.

Why did bond yields rise?

Three factors appear to have driven the move in yields this week.
  1. It was a strong week for U.S. economic data. The highlights include:
  • The ADP employment report showed private payroll gains of 230k jobs in September, beating consensus (179k).
  • US ISM services PMI hit 61.6, a 21-year high. The Markit PMI also rose to 55.6 from 54.7 last month. In particular, the strength in domestic new orders help boost the reading.
  • Light vehicle sales, a good measure of trends in consumer spending, rose sharply to 17.4M, up from 16.6M in August.
  • The move higher in yields as of today, is on the back of a strong employment report that came out this morning, in which the unemployment rate fell to 3.68%, the lowest rate since December 1969.
  1. Hawkish commentary from Jerome Powell’s speech on Wednesday followed the strong economic data.
He commented the U.S. economy is “remarkably positive” and that the current expansion can continue for “quite some time, effectively indefinitely.” Moreover, and what seemingly drove markets, was his statement that it may be necessary for the Fed to raise rates beyond an estimated neutral level, which we are still a “long way” from. The Fed Funds futures priced a December rate hike at 76%, up from 50% just six weeks ago.
  1. Automatic selling by technical trading desks
Yields breaking past the 3.20% level, may have caused some bond funds that run on algorithmic trading platforms to trigger a sell signal. This may have further exacerbated the immediate market reaction.

As shown, the move higher is a repricing of real growth expectations rather than a rise in inflation fears. The yield on a Treasury Inflation-Protected Security (TIPS), a proxy for real growth, increased 10 bps alongside nominal yields which rose 14 bps.  

What does this mean for investors?

With a backdrop of robust economic growth, stable inflation and a Fed firm in their rate hiking path, we do believe yields will continue to move higher gradually over the near-term. In this environment, traditional fixed income will likely continue to be a challenging environment for investors and more pain can be expected.

Investors should look at this move in the context of a broader, more drawn out, rise in nominal yields and not abandon the asset class altogether. We believe that the current backdrop favors a diversified approach to fixed income investing, and that areas such as floating rate, TIPs and high yield could provide both yield enhancement and some price protection for portfolios.

Real growth expectations pushing nominal yields higher, not inflation

Change in yields as of June 2018, bps

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Source: Federal Reserve, FactSet, J.P. Morgan Asset Management.