(Bloomberg) — The world’s biggest bond market is showing signs of concern that Russia’s invasion of Ukraine could have economic consequences the Federal Reserve is eager to avoid: persistent inflation and weak economic growth.
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Bond-market gauges of short-term inflation expectations rose to record lows during the past week as oil and natural gas escalated into the unfolding crisis. At the same time, the gap between short- and long-term returns narrowed, reflecting expectations of an economic slowdown.
Investors scrutinized Treasuries, which provide protection against inflation, even as traders are speculating that the Fed will cut rates in 2024 after a series of hikes beginning next month. Strategists at Bank of America Corp advise clients to start positions for stagflation, a mix of rising prices and steady growth that America hasn’t seen in a generation.
“The Russia-Ukraine crisis has accelerated the inflationary trend,” said Tracy Chen, portfolio manager at Brandywine Global Investment Management. “Higher commodity prices will slow down growth and lead to inflation. The Fed will be further behind the curve.”
The Treasury market briefly served as a refuge for investors after the Russian invasion plunged stock prices around the world. But equities rebounded, and yields followed suit as anticipation of rising interest rates moved back into the foreground. The benchmark 10-year yield dropped less than 2% in the week, near a high earlier this month. Yet the two-year yields jumped even further, reducing the gap between the two to just 40 bps from 45.5 bps a week ago.
The coming week will be crucial for investors looking to assess the outcome of the Fed’s mid-March meeting, when it is widely expected to raise its policy rate to zero, where it has been since the start of the pandemic.
Fed Chair Jerome Powell will testify before Congress on Wednesday and Thursday, providing policymakers with insights before entering their pre-meeting communications blackout period. On Friday, the Labor Department will release its monthly jobs report, which is expected to accelerate wage pressure despite slowing payroll growth amid a tight labor market.
While the Ukraine crisis prompted traders to mark the odds of a half percentage-point increase in March, they continue to anticipate a quicker but shorter tightening cycle.
The implied yield on eurodollar futures maturing in 2024 is about 17 basis points lower than on the 2023 contract, suggesting traders are pricing in a higher probability of a rate cut within three years.
“What this means is that inflation will remain high, and the expected Fed is going to be the catalyst for more slow growth,” said Cathy Jones, chief fixed-income strategist at Charles Schwab & Co. “I wouldn’t call it a stagnation. Growth is not stagnant, but is going to slow down, with that inflationary momentum going to take a while.
The escalation of the conflict led to a major reversal this week in the fortunes of Treasury inflation-protected securities – known as TIPS – as more price pressures are expected to mount. These securities compensate investors for the hit of inflation and therefore offer lower yields than their plain-vanilla Treasury counterparts.
Demand for TIPS faltered in January and early February as Fed officials began to take a more militant tone. Yet it rebounded after the attack, reducing the yield on the five-year TIPS, down 39 basis points on Thursday, to touch negative 1.61%. Yields at the end of the week hovered around a negative 1.2%.
Bank of America’s chief investment strategist Michael Hartnett said the war in Ukraine increases the risk of a deadlock and missteps by the Fed.
“The portfolio must create conditions for a stalemate and a fall in the dollar,” he wrote in a note with his colleagues. “In the 1970s it increasingly appears real assets, commodities, TIPS, small cap values and EMs.”
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February 28: Balance of Trade, Wholesale Goods, Chicago PMI, Dallas Fed Manufacturing Activity
March 1: Construction Expenses, ISM Manufacturing, Vehicle Sales
March 2: ADP Employment, Fed Beige Book
March 3: Challenger job cuts, productivity and unit labor costs, jobless claims, ISM services, factory orders
March 4: Employment
February 28: Rafael Bostico, President of the Atlanta Fed
March 1: Bostic
March 2: Fed Chair Powell, Chicago Fed President Charles Evans, New York Fed Executive Vice President Laurie Logan
March 3: Powell, New York Fed Chairman John Williams
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