Investors 'underestimating the potential weakness' in bonds, says strategist

Treasury yields move higher amid Central Bank rate hikes. Katy Kaminski, AlphaSimplex Chief Research Strategist and Portfolio Manager, joins Yahoo Finance Live to break down what to know about investing in the bond market.

Video Transcript

BRAD SMITH: The Bank of Canada actually shocked markets with a 2s5-basis point rate hike yesterday joining the Reserve Bank of Australia in continued tightening paths in an effort to tame inflation.

The moves by these central banks are sending yields higher as investors rethink their bets on rate cuts later this year. And even consider the possibility of more tightening from the Federal Reserve. We're back with Katy Kaminski, who is the Alpha Simplex Chief research strategist and portfolio manager here.

So as we weigh the different central bank policies that are being moved forward with throughout the world, if you're the US now looking at what other entities are doing, what does that set up for the talks at the next meeting here?

KATY KAMINSKI: Well, I think what's interesting today is you're thinking about a situation, bets that they would actually hike were very low until recently. I heard a stat today. It's roughly around 30% view that they might still hike.

And that has creeped up a lot. Another thing to note in the last two weeks, interest rates have been going up as well. So the market is really starting to focus a little bit more that hey, wait a minute, data is not a slam dunk here. It is not clear that inflation is going to go down quickly. We're in a very difficult situation. And that as long as inflation stays high, the Fed's mandate is to regulate it. Thus, we're probably going to be here longer than people would like. And as long as we're hoping that things will pause, then people Are buying. Because they're thinking it's probably not going to be that bad.

JULIE HYMAN: So let's talk about the implications for the bond market of all of this, which you touched on a little bit before. Because there's a lot of other things that are at play in the bond market, in addition to just watching the Fed, there's the fact that the Treasury is now going to be selling what worth of securities that got backed up during the debt ceiling situation.

So what are the implications for not just bond prices, but also the competitive nature of equities and bonds here?

KATY KAMINSKI: Well, I think the biggest challenge this year is that you've seen that the bond markets and the stock markets have disagreed. Stock markets have looked like, we're probably going to get a soft landing. Let's figure this out. Whereas. bond markets with the inversion in the curve, have been, in some sense warning us of a recession.

And so what we're seeing now is that stock markets are looking pretty strong. But bond markets have to react, if we should actually pause or have less tightening.

Just think it about this way. Inflation is high. The Fed pauses. What happens to long-term cash flows? They're at risk, as long as we don't see inflation go down fast enough. So I think people are underestimating the potential weakness in fixed income. And this is particularly true during rising rate environments. Something that most of us haven't seen throughout most of our investment career.

Looking at statistics over empirical periods with higher inflation, fixed income struggles. When you have higher rates. And when you have inflation, thus, I would expect the longer end of the curve to break out. We're getting closer to there now we've seen a little bit of movement more recently. Although, earlier in the year, we hit close to a 10.4% on the 10-year.

The question is going to be, could we eventually have a breakout where we have a steeper curve? But at the same time isn't There really a support under the bond market right now because people want that yield.

KATY KAMINSKI: I agree there is. But I think I've been asking this question over and over again was internally in the office. When is this going to happen? When are we going to have a steeper yield curve? And I think what we think is that it's going to take a realization from investors. Wait a minute, inflation is really going to stick around longer.

Wages are going to be stickier. Wage pressure. And, thus, you'll actually have to think about the implications for long-term cash flows. So far, the market is still hasn't realized that yet. Hit 4% on the 10-year and see if it keeps going. And I think that could be an indication.

JULIE HYMAN: Just a really quick follow here. If we're getting a steeper yield curve, does that also mean lower probability of recession?

KATY KAMINSKI: Let's hope so.

JULIE HYMAN: Because you're talking about some other factors here.

KATY KAMINSKI: Yes. We have always been saying that we think the bond market is going to be the first to fall. So you're looking at a first, equities look good. They're very optimistic. then people realize, wait a minute, inflation is sticky. That's not great for everything. What's the catch? That would be the bond market actually bottoming out. So we would see the bottom of the bond market first. And then after that, in the wake of that, if we don't have sufficient growth, then that's when you're going to see equities are going to be at risk.

The problem is that's a multiple step question, whereas, right now, where we are, most investors are just thinking about the next quarter. Thinking like, OK. This is looking good.

JULIE HYMAN: They always do.