U.S. Treasuries rode a wave of momentum into December amid a confluence of perceived risks around the outlooks for central bank policy, inflation, and a new variant of COVID-19. In response, investors have bid up prices of sovereign bonds, pushing yields lower, while stocks suffered losses.
The risks driving these moves may persist into year-end and could contribute to volatility across financial markets. The U.S. Federal Reserve now faces a balancing act as it looks to taper the bond-buying program it implemented last year to counteract the economic effects of the pandemic. Other central banks confront similar policy challenges.
Making waves across yield curves
The U.S. yield curve seesawed in November, reflecting shifting expectations for inflation and monetary policy.
Treasuries rallied at the start of the month as the spread between the five-year note and the 30-year bond, known as the 5s30s yield curve, steepened. This came after dovish moves from some central banks surprised investors, including the Bank of England (BOE) maintaining its policy rate rather than raising it, and European Central Bank (ECB) pushing back against market pricing that signaled expectations for interest rate hikes.
U.S. yields then moved higher toward mid-month, led by the front end of the curve, after data showed a continued acceleration in inflation, and as several Fed officials spoke about increasing the pace of tapering. The 5s30s yield curve flattened to 60 basis points (bps), a level not seen since early 2020.
Then, on what was supposed to be a quiet, shortened trading session after Thanksgiving, markets were surprised anew by the emergence of the omicron variant of COVID-19. The subsequent risk-off move saw sovereign bonds rally globally. Five-year Treasury yields fell 18.5 bps, the largest day-over-day rally since March 2020.
Concerns over omicron persisted into month-end, with the Treasury rally most pronounced in shorter-dated notes, given the complications the new variant may pose to central bank monetary tightening. In turn, the 5s30s curve briefly steepened back to 75 bps.
The curve quickly retraced flatter to end the month, however, following Fed Chair Jerome Powell’s hawkish comments to the Senate Banking Committee on 30 November, in which he indicated the Fed may accelerate the withdrawal of monetary stimulus. The 30-year Treasury bond traded at its lowest yield of 2021, at 1.79%. The 10-year note, which traded in a 26-bp range of 1.42% to 1.68% during November, closed the month at the low end of that range.
Taper talk and policy predicaments
The outlook for monetary policy remains front-of-mind for investors. The Fed on 3 November laid out plans to reduce its asset purchases by $15 billion a month, beginning in mid-November. The central bank left itself room to adjust the pace at its December meeting if needed.
The Fed initially stuck with its message that inflation remains high due to factors that are expected to be transitory, while building in some flexibility in light of upside risks. However, in his Senate testimony, Chair Powell acknowledged that it may be time to retire the term “transitory” and said the risk of higher inflation has increased.
Investors at least face one less variable on the policy front after President Joe Biden last month renominated Powell for a second four-year term as Fed chair, ensuring continuity at the central bank, while also elevating Governor Lael Brainard to the position of vice chair of monetary policy.
The recent confluence of uncertainties, along with liquidity constraints that often affect financial markets at year-end, could be a recipe for volatility heading into 2022. The challenges facing central banks globally are complex, but they can also create opportunities for active investors that can nimbly respond to divergences in policy and asset prices. In light of inflationary risks, it may be worth considering investments that are highly correlated with inflation, such as inflation-linked securities and commodities, as well as strategies involving yield-curve positioning.
For PIMCO’s latest Secular Outlook, please read, “Age of Transformation.”
Rick Chan is a portfolio manager focusing on global macro strategies and relative value trading in interest rates. Abhishek Nadamani is a portfolio manager on the U.S. rates desk. Christopher Youssef is a portfolio manager focusing on interest rate relative value trading strategies.