U.S. government bonds rallied and banking and insurance stocks tumbled in the latest signs of rising anxiety hitting financial markets.
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The action reflects a warning from a Federal Reserve official Tuesday that persistently low inflation could make it difficult for the central bank to continue raising interest rates as many investors expect. Adding to the pressure, Hurricane Irma is threatening the U.S. coastline and the U.S. is facing a potential confrontation with North Korea over nuclear tests.
The Dow Jones Industrial Average fell 234.25 points, its largest one-day decline since Aug. 17, while gold, a haven in turbulent times, settled at its highest value since last September. The yield on the benchmark 10-year U.S. Treasury note fell to 2.072%, its lowest close since Nov. 9, the day after the U.S. presidential election. Bond yields fall as prices rise.
Tuesday's bond rally added to a two-month decline in Treasury yields, largely driven by a run of soft inflation data, which investors have been less willing to dismiss as resulting from one-time factors than some Federal Reserve officials.
Some investors said the combination of events Tuesday heightened concerns that many already had about the economy and global politics.
Skepticism toward the inflation outlook is shared broadly by investors, if not the majority of Fed policy makers, who have long said they expect inflation to trend higher. Implied inflation expectations, derived from the difference between nominal and inflation-adjusted Treasury yields, are forecast to be about 1.79% annually over the next decade, according to data from Tradeweb. That's down from more than 2% earlier in the year.
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While North Korea's latest nuclear test and Hurricane Irma helped bolster Treasurys, the long-term argument for buying bonds also got a boost Tuesday from Federal Reserve governor Lael Brainard, who said in a speech that the Fed's "persistent failure" to hit its 2% inflation target could merit a slower path of interest-rate increases going forward.
"We have been falling short of our inflation objective not just in the past year, but over a longer period as well," she said. "My own view is that we should be cautious about tightening policy further until we are confident inflation is on track to achieve our target."
Ms. Brainard has expressed concern about low inflation before. But her latest remarks came at a critical time, as Fed officials gear up for a debate over whether to stick to the central bank's plan of raising interest rates a third time this year or hit the pause button to wait for more inflation data and see how the economy and markets react to the latest political fights in Washington and natural disasters.
The decline in yields and the low spread between the two- and 10-year Treasury note are bad for banks. Banks in recent years have suffered from a narrow spread, which leads to a thinner gap between what they pay on deposits and charge on loans, a spread known as their net-interest margins.
Those margins had recently ticked up slightly, leading investors to expect bank profits could soon expand. Tuesday's bond-market action cast doubt on that expectation.
Shares of J.P. Morgan Chase & Co. fell 2.4%, BankAmerica Corp.'s shares fell 3.2% and Citigroup's shares lost 2.1%. Shares in financial firms that aren't as sensitive to interest rates and lending, such as Goldman Sachs Group Inc. and Morgan Stanley, also fell sharply.
Insurers were among the S&P 500's biggest decliners, as Hurricane Irma threatened to do more damage to the U.S. coastline. Everest Re Group declined 6.9%, XL Group fell 5.8% and Travelers Cos. lost 3.7%.
Low inflation makes government bonds more appealing to investors because it helps preserve the purchasing power of their fixed payments. It also makes it less likely that the Fed will raise interest rates, which is another major threat to the value of outstanding Treasurys.
Since topping the Fed's 2% target in February, one of the Fed's preferred inflation measures, the personal-consumption expenditures price index, has been in retreat, rising just 1.4% in July from a year earlier, the Commerce Department said last week.
The inflation slowdown has surprised many investors and analysts because it has defied many economists' expectations that a low jobless rate should soon lead to higher wages and costlier goods and services.
The U.S. unemployment rate was 4.4% in August, just off a 16-year low, but wage growth and inflation have both remained sluggish. That has left investors debating whether tepid inflation and low bond yields could be the result of large, potentially intractable forces, such as globalization and technological advances, rather than just a consequence of the normal economic cycle.
"I think there's something really powerful" happening, said Rick Rieder, chief investment officer of global fixed income at BlackRock Inc., the world's largest asset manager. Technological innovation from companies like Amazon.com Inc. and Uber Technologies Inc., he added, are behind "the greatest cost revolution of all time," in a development that has far-reaching consequences for financial markets.
For years, some analysts have argued that technology and increased global competition as well as aging populations and mounting debt levels could all play some role in holding down economic growth, inflation and bond yields. What has changed, investors and analysts say, is how seriously these arguments are now being taken by market participants.
In recent years, investors have frequently blamed low yields on factors including monetary stimulus from major central banks or fears that the global economy could soon tip into another recession. But the Fed now has plans to start slowly reducing its large portfolio of Treasurys and mortgage-backed securities, after already raising interest rates twice this year.
Meanwhile, many investors also expect the European Central Bank to soon start scaling back its own stimulus program, as the entire global economy shows signs of improvement.
"When everything tells you that inflation is supposed to be going up and then it doesn't, people begin to fall back to something out there that is structural," said Jim Vogel, interest-rates strategist at FTN Financial.
Structural factors like high debt levels and technological innovation are working alongside cyclical factors to hold down U.S. inflation, said Jan Dehn, global head of research at Ashmore, the emerging markets-focused money manager.
"If you can sell the message that inflation is low for structural reasons, then naturally you have a reason you shouldn't touch rates," he said. As a result, he believes a benign rate environment and weakening dollar will persist for some time.
That was a key reason behind his firm's decision last year to shift a big chunk of its assets from emerging-markets corporate debt to the local currency debt of emerging-market governments, which would benefit from a weaker dollar. He believes it could be a five-year trade.
Hoisington Investment Management Co. in Austin, Texas, invests in long-term Treasurys and zero-coupon bonds, reasoning that overindebtedness in the U.S. and other cyclical and structural factors have long kept inflation low.
"Brainard's was one of the most candid statements that I've seen but this could have been given before now," said Lacy Hunt, the firm's executive vice president.
(END) Dow Jones Newswires
September 05, 2017 20:21 ET (00:21 GMT)