Reprieve in the Higher Rate Cycle

Nominal 10-year yields have hit their peak, if not of this cycle, then at least over the rest of 2022.  On a day when the US showed consecutive quarters of shrinking GDP growth it feels appropriate to discuss the competing factors driving interest rates and why odds are high that the reprieve to higher rates has legs. We can see this thematically in the chart that plots real US 10-year rates against the copper/gold ratio which serves as a proxy for economic growth.

Prior to QT (Quantitative Tightening) and rising policy rates it was clear real yields were absurdly low. Such is the power of QE. Now, not so much. That is evident in the 140bp rise in real yields this year meeting a falling copper/gold ratio and more coincident economic data such as the GDP data this morning. This doesn’t mean real yields should fall much from here. After all, supply/demand conditions for bonds also affects real yields and the full impact from QT will keep yields biased to the upside.

But it does suggest a sort of equilibrium is taking shape, at least for the remainder of the year. Real yields fluctuating in a range seen in the 2013 period leading up to Covid in 2020 feels like a good bet. If so, then nominal rates will be primarily driven by an inflation premium.

Over the past several months that premium has fallen sharply accounting for much of the recent decline in nominal yields. Inflation expectations have fallen on weaker growth prospects, moderating wage inflation, easing supply bottlenecks, falling commodity prices and credibility that the Fed will succeed in fighting inflation. In effect, this too feels rangebound, and likely on the lower bound, as we move beyond peak inflation fears.

Taken together, receding inflation risks and steady market rates will take some sting out of further rate hikes over coming months and ease some of the pressure on multiple compression that has driven the equity market sell-off in 2022.  

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