Industrial Forex: Bank of America warns that the door to the "5% world" has opened

Bond traders around the world are finally waking up to the possibility that the lowest yields in recent history may be gone for good as the astonishing resilience of the US economy, ballooning debt and deficits and growing fears that the Federal Reserve will keep interest rates high are pushing the yield on the longest-dated US Treasury bond back to its highest level in more than a decade.

This has prompted a rethink of what a "normal" Treasury market would look like.

Bank of America strategists have warned investors to prepare for the return of a "world of 5 per cent".The "5 per cent world" prevailed before the global financial crisis forced the US into a prolonged era of near-zero interest rates, and both BlackRock and Pimco said inflation was likely to remain stubbornly above the Fed's target, leaving room for longer-term yields to rise further.

Jean Boivin, a former Bank of Canada official who now heads the BlackRock Investment Institute, said:Long-term interest rates have seen a significant increase in repricing"There is a growing belief that, despite recent progress, long-term inflationary pressures will persist," he said. "Macroeconomic uncertainty will remain an issue in the coming years, requiring greater compensation for holding long-term bonds."

This is a clear decoupling for markets, which began preparing for a recession last year on the assumption that it would prompt the Federal Reserve to loosen monetary policy, raising hopes that the bond market will rebound sharply from brutal losses in 2022, when Treasuries recorded their biggest decline since at least the early 1970s.

While a rate hike would soften the blow by raising interest payments for bondholders, it could also put pressure on everything from consumer spending, home sales, tech stock prices, and more. More importantly, a rate hike would increase the cost of funding for the U.S. government, which has already been forced to borrow about $1 trillion this quarter to fill the gap. The decline since last week has hit long-term Treasuries the hardest and wiped out gains in the overall Treasury market this year, putting it on track for a third straight year of declines. U.S. stocks have also been dragged down, having rallied strongly until this month on expectations of the Fed's path.

The latest transformation may beDeviation from underlying forecastSome Wall Street forecasters still expect an economic contraction, putting downward pressure on consumer prices. Moreover, inflation expectations remain stagnant this year as the pace of inflation has slowed sharply from last year's highs, suggesting that markets expect inflation to eventually fall back to near the Fed's 2 per cent target. The personal consumption expenditures index, the Fed's preferred measure of inflation, rose 3 per cent in June. That is down from a high of 7 per cent a year ago.

But many now expect a soft landing in the US, which would make inflation the main risk.This was underscored this week by FOMC meeting notes for July, when officials expressed concern that further rate hikes might still be needed. They also hinted that the reduction in bond holdings could continue even if the Federal Reserve decides to cut interest rates to reduce policy constraints.This could continue to weigh on the bond market。

Treasury yields rose for a sixth straight day on Thursday, with the yield on the benchmark 10-year bond climbing as high as 4.33 per cent. That was only slightly below the highest since 2007 set in October, and the yield on the 30-year note hit a 12-year high of 4.42 per cent.

The broader economic changes have also prompted speculation that the low interest rates and low inflation in the post-crisis period were an anomaly.Industrial foreign exchangeEconomists judge demographics as likely to push up wages as older workers retire; deglobalisation; and fighting global warming by reducing the use of fossil fuels. Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group, said: "I don't want to hold long-term bonds if inflation stays high. People will need more term premiums to hold long-term bonds", referring to the fact that investors typically demand higher returns to be willing to take longer-term risks.

However, despite the recent rise in yields, this premium has not returned. In fact, as long-term rates are lower than short-term rates, the premium on this front is still negative, but the spread has started to narrow, with the term premium as measured by the New York Fed falling from about -1% in mid-July to around -0.56%. The upward pressure on this premium has also been exacerbated by US federal spending. Although the US economy is still at or near full employment, federal spending is leading to a flood of new debt issuance to cover the deficit. Meanwhile, the Bank of Japan has finally decided to allow its 10-year Treasury yield to move higher, which could reduce Japanese demand for Treasuries.

BlackRock's Boivin says,The world's central banks are undergoing a major transformationHe said that for years, these countries have kept interest rates well below what is considered neutral to stimulate their economies and fend off deflationary risksNow the situation has reversed, so even if the long-term neutral rate remains unchanged, central banks will maintain policies above neutral rates to avoid inflationary pressures.