Five Reasons Bond-Market Pessimism May Be Overblown

Volatility in the U.S. Treasury market has intensified in recent weeks, with the Merrill Lynch Option Volatility Estimate (MOVE) index, a bond-market fear gauge, soaring 45% since mid-September to a level last seen in March of 2020, at the onset of the pandemic recession. 

Importantly, two-year Treasury yields, which are highly sensitive to interest rate expectations, have about doubled over the past month to roughly 50 basis points, signaling market expectations that the Federal Reserve may have to begin raising rates earlier—and at a faster clip—than currently planned in order to help contain inflation. This spike, in turn, has helped narrow the difference between the two-year and 10-year Treasury yields, suggesting that bond investors are also worried about slowing economic growth ahead.

At the heart of the recent market action: Bond investors seem to be growing less and less convinced of the Fed’s assertion that inflation will prove “transitory” and increasingly concerned that policymakers may be late in tightening policy amid persistent inflation.  

That’s probably a fair assessment, given that supply-chain constraints are expected well into next year and that cost pressures persist across wages and commodities. The Fed has revised up its own inflation expectations to 3.7% for the core personal consumption expenditure (PCE) price index this year—but even that falls short of actual inflation readings of 4.4% for the PCE price index and 5.4% for the consumer-price index.

However, we believe the bond market may be overly downcast on the U.S. economy's growth potential. In our view, a number of structural drivers will likely fuel strong demand and growth, including:

• Historically high U.S. household savings, estimated at above $2 trillion, that could fuel consumer spending;

• A technology and digitization cycle that is driving both disruption and heavy corporate spending in virtually every industry;

• An infrastructure re-build that could come with more fiscal stimulus;

• Shifting demographics toward a younger workforce entering their prime; and

• A U.S. banking system that is well capitalized to lend.

So, while the bond market’s concern about inflation and Fed policy appears somewhat sober, its gloomy forecast on growth prospects seems exaggerated. At the same time, expectations for the stock market seem too rosy. Equities continue to set records, seemingly undeterred by the bond-market volatility, thanks in part to solid corporate earnings rolling in.

The truth probably lies somewhere in the middle. Markets are likely to recalibrate, with shorter-term Treasury bond yields easing and the 10-year yield inching up, causing the yield curve to re-steepen. Equities will need to catch up to the reality of tightening financial conditions ahead. Our research shows that the Fed could begin tapering its asset purchases starting in November, the next interest rate hike could occur in less than 10 months, and the pace of subsequent rate hikes could quicken. And, as price pressures stabilize, we could see inflation-linked bonds sell off. In this environment, investors should consider reducing current Treasury inflation-protected security positions and expensive long-duration secular growth stocks, which are sensitive to rising real rates. The financials sector remains our favorite global long exposure.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Nov 1, 2021, “Behind the Curve.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.