Bond prices collapsed this year as central banks aggressively increased interest rates in a bid to battle inflation.
Where bond prices go in 2023 will primarily be determined by how much the global economy slows and how “sticky” inflation proves to be. If inflation takes a while to come down, interest rates may need to rise from current levels.
The Federal Reserve Bank of Atlanta measures the “stickiness” of inflation through its 12-month sticky-price consumer price index (CPI) – a weighted basket of items that tend to change price slowly. This measure of inflation is running at 6.51%, the highest level since 1982.
Historical data show that only after the effective federal funds rate has surpassed the sticky inflation rate, as happened in 1980, do we see downward pressure on interest rates. Based on the current effective funds rate of 3.83%, interest would still need to rise by 2.68% to reach the 6.51% sticky inflation rate.
Overnight rates could move above 5%
Given the high sticky inflation rate, it seems unlikely that the US Federal Reserve has finished raising interest rates. This view is supported by the fact that Fed governors are talking about raising the overnight rate to between 5% and 5.25% in 2023.
The longer that the so-called sticky inflation remains at its current level, the higher that overnight rate will have to go to bring inflation down.
A 5.25% overnight rate suggests that the two-year treasury rate needs to rise above its current level of 4.48% to around 5%. This rate has been tracking the December 2023 Fed Funds Futures contract and currently trades at a 17-basis-point discount to the December contract.
However, if the Fed intends to keep rates steady after they reach the terminal rate, a 5.25% December 2023 overnight rate looks probable. The Federal Open Market Committee may offer commentary on this point at its December meeting – look out for the Summary of Economic Projections which the Fed publishes online.
If the Fed wants to drive the point home that rates will be elevated for some time, it could mean a 5% to 5.25% terminal rate in 2024. This is much higher than current market expectations of 3.75%.
This message would undoubtedly push the two-year treasury note towards 5%, dragging the entire treasury curve higher. Even if we use the current yield curve inversion of 71 basis points on the two-year and 10-year spread, a two-year rate of 5% to 5.25% suggests a 10-year rate of 4.25 to 4.5%. Whether the curve will grow wider is up for debate, but it is currently at its deepest point in 40 years.
Technical trends suggest the two-year rate could rise
The two-year is still holding on to both the long-term uptrend, which started in August, and the short-term uptrend that began in early October. It almost dropped below both trend lines this month, but bounced back and rose above the two trend lines, suggesting a failed breakdown attempt. From here, the two-year could climb to 5%.
Additionally, the two-year could form a technical reversal pattern known as a head-and-shoulders pattern. However, if the pattern fails to be validated with a neckline break, the usually bearish reversal pattern could become a bullish continuation pattern, as we witnessed in the 10-year rate earlier this year.
The 10-year could be dragged higher
While the 10-year has fallen, it has not broken down. There are still two upward-pointing trend lines that suggest the 10-year could continue to push to higher levels – possibly as high as 4.55%.
Based on the Fed’s messaging around inflation, there is a distinct possibility that interest rates could go higher and bond prices could move lower. These outcomes seem likely, unless or until the Fed changes its tune on monetary policy, or there is clear evidence that both headline and sticky inflation are falling. For now, though, the path of least resistance for rates appears to be upwards.
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