Scott Peng, the founder and chief investment officer of New York investment manager Advocate Capital Management, has been out in front of the collapse of the bond market.
In Jan. 2021, Citi’s former chief interest-rate strategist forecast the 10-year U.S. Treasury yield TMUBMUSD10Y, 3.115% to reach 2.5% in 12 months — it took about 15 months to get there. More recently, he said in December that interest rate sensitive asset classes would struggle, identifying technology stocks NDX, -5.06%, high yield bonds JNK, -1.80%, emerging markets and real estate, all of which have dropped sharply.
So the big question from here is whether the bond market pain will continue or not. Peng says it will, forecasting the 10-year yield will reach 4% by the end of this year, and 5% by the end of 2023. The yield on the 10-year was 3.11%, about a half-hour after the latest U.S. jobs report that came in close to market expectations.
Peng points out that Federal Reserve Chair Jerome Powell made an interesting comment during the press conference on Wednesday, that the Fed’s tools don’t work on supply shocks but rather demand. “It may require considerably more hikes than the market has experienced in recent years before the Fed can get ahead of this bout of supply-shock-driven inflation,” Peng says.
The demand shock from pent-up consumption after the pandemic, he adds, has already dissipated. At the same time, China is no longer a source of supply-side relief, both as the country shifts to higher value-added services as well as its decision for a zero-COVID policy that has exacerbated supply-chain issues. China’s aging demographics mean the world’s second-largest economy faces a rising tide of labor shortages and wage inflation, he adds.
Peng says the Fed funds rate will have to be at least 1.5% above the core personal consumption expenditure index (PCE) measure of U.S. inflation, which was 5.2% year-over-year in March. He said the current market consensus is just for what he calls a “dream on” scenario, that implies core PCE running at 2% by the end of 2023.
More likely scenarios would have inflation between 3% and 4%, or possibly 5%, which would therefore mean the terminal rate reaching between 4.5% and 8%. In a “time for new Fed chair” scenario, the terminal rate could even need to go as high as 9%.