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28/06/22, 12:57

Smiling Young Businessman

Darrell Delamaide

Darrell Delamaide is a freelance writer and journalist based in Washington, D.C.

He has specialized in business and finance over a long career. Darrell has writen for Barron’s, Dow Jones, Institutional Investor, and Bloomberg among others.

He has produced extensive coverage about economic and monetary policy, banking, capital markets, politics and regulatory affairs.

A longtime correspondent in Europe, Delamaide also has written about global economics, global markets, foreign policy, and other international topics.

Government Bond Investors Torn Between Growth And Inflation

Investors in US Treasuries face a dilemma as they are caught between an economy that seems very strong but faces challenges from soaring inflation and Federal Reserve rate hikes to cut it off and keep inflation expectations anchored.

Yields on the 10-year Treasury note resumed rising in Monday trading, hitting above 3.2% in late trading after retreating last week to near 3.0%. The yield curve remained flat with the 2-year note yield registering just above 3.1% on Monday and the 30-year bond yield topping 3.3%.

Positive economic data continued to come in on Monday. Durable goods orders were up 0.7% in May, which was stronger than expected. Even more telling, pending home sales were also up in May after six months of decline.

Fed Chairman Jerome Powell insisted in congressional testimony last week that central bank policymakers were willing to hike rates until inflation is contained, even if it means tipping the economy into recession.

One of those policymakers, St. Louis Fed President James Bullard, expressed optimism last week about the strength of the economy even as he pushed for aggressive rate hikes. Bullard is one of the four regional Fed bank presidents in a voting position this year on the Federal Open Market Committee, which decides on monetary policy.

Technical analysts reflect the investors’ quandary. They are seeing a 3% yield on the 10-year as a support level – if the yield goes below that, it will probably descend even further. If the 10-year yield keeps moving upwards and hits 3.5%, then it could rise further, they say.

For now, the yield is bouncing around between those thresholds as investors are pulled first one way, then another.

Meanwhile, “fragmentation” has become the buzzword for eurozone government bonds, as the prospect of monetary tightening widens the gap between the more heavily indebted countries in the southern periphery and the fiscally conservative northern countries.

European Central Bank policymakers, starting with President Christine Lagarde, are insisting that they will act to prevent the yield gap from widening too much. Not only does that make the transmission of monetary policy more difficult, it threatens the very stability of the joint currency.

The closely watched spread between yields on the German and Italian 10-year bonds has widened by 100 basis points – a full percentage point – over the past 12 months, with half of that rise coming since March.

Memories of the euro debt crisis a decade ago are still very fresh, though as ECB policymakers don’t tire of pointing out, that weaker countries are stronger now than they were then and a central bank that has navigated the COVID-19 pandemic has more tools and flexibility than it did then.

But some of the pandemic policies – notably the support for government bonds with central bank purchases – have lulled investors into a feeling of complacency. Withdrawal of that support makes it likelier that they will test the ECB’s commitment to avoiding fragmentation.

Lorenzo Bini Smaghi, a highly regarded former member of the ECB executive board, urged the central bank to become even more flexible and eliminate self-imposed limits on its bond purchases from reliance on bond ratings by North American rating agencies. These tend to be procyclical Bini Smaghi argued in a Financial Times op-ed.

Other potential solutions, such as the Outright Monetary Transactions mechanism created during the debt crisis, entail conditionality that is politically challenging for national governments. In any case, ECB tools must have unlimited capacity to withstand market challenges, the Italian economist argues.

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