One of the great skills of the best forecasters is to explain the past and make market moves sound perfectly logical and predictable. I say this tongue in cheek because I have been mulling the causes of the recent rise in US treasury yields. Last week, I read a flurry of notes explaining why global bond yields have gone up.
I have been on the wrong side of this move. Although not outright bullish, we have been extending duration in recent months as we felt recession risks look to be understated. But let’s just look at what has happened recently.
Three months ago, the US 10-year yield was hovering around 3.5%. There was a move up to 3.8% in late May and a short spike above 4% in early July. In the last four weeks, yields have been moving upwards, breaching 4.3% last Thursday. For someone like me, who has seen US 10-year rates at double these levels, current yields are not abnormal. But they do represent a 15-year high. And this is against a background in which investors are pricing a peak in the US interest rate cycle and with signs that inflationary pressures are cooling. It is not just about 10-year rates. Another feature is the rise in longer term yields. Yields on 30-year treasuries went above 4.4% for the first time since 2011. Indeed, we have seen long-term rates increase by more than 10-year rates in recent weeks.
One explanation could be that inflation expectations are increasing. Despite headline declines, investors may be sensing that the US Federal Reserve (Fed) will tolerate a higher level of inflation than they are letting on. Or that the US government will not countenance the consequences of squeezing inflation back to 2%. We have an easy way of checking this. Looking at the spread between nominal and real yields, as represented by Treasury Inflation Protected Securities (TIPS), there is no discernible change – with the differential being maintained below 2.5%. Fair enough, this is above the Fed’s inflation target but seems to me that investors have bought into 2% – with a small insurance premium thrown in.
What we are left with is a rise in real yields and this is a global story. Back in the depths of the Covid crisis, 20-year US real yields were -0.5%, that is, investors were prepared to accept a return of less than inflation over a 20-year period. Last week saw 20-year US real yields approach 2.2%. What this means is that investors can achieve a US government guaranteed return of inflation plus 2%, if held to maturity. In today’s world that looks attractive. In the UK, the picture is even more stark. 10-year nominal gilt yields ended the week just under 4.7%, a far cry from the sub 0.1% seen in 2020. UK real yields have followed suit with the 20-year rate more than 4% higher than the low point. Investors ask why, in a period of rising inflation, have index linked gilts been such a poor investment? The answer is that the rise in real yields has overwhelmed the value uplift arising from higher inflation.
Credit markets reflected the move higher in real yields. In sterling investment grade, spreads were a touch wider with weakness seen in financial bonds. The move in high yield markets was more pronounced with spreads about 20 basis points higher on the week. Renewed concerns about the Chinese property sector unsettled sentiment, although the actual impact on indices was limited given the low weighting.
So let me explain why the most recent rise in real yields has happened (refer to first paragraph please). First, US growth is turning out to be more resilient than expected. Corporate margins are holding up well, the US consumer is coping with higher mortgage bills and fiscal initiatives such as the Inflation Reduction Act (lovely misnomer, replace with ‘Protection’) are supporting businesses. Second, Japanese monetary policy has changed. Instead of keeping 10-year yields at or below 0.5%, the Bank of Japan is targeting a maximum rate of 1%. It does not sound like a big change, but it has consequences for all bond markets – with 10-year Japanese yields going from 0.45% to 0.65%. Although primarily a domestic market, the scale of Japanese government debt is massive and the policy of keeping rates at 0.5%, through market purchases, had a major impact on global monetary conditions. Less support for Japanese yields means tighter global monetary policy – and higher real yields. Third, price is determined by supply and demand factors; if supply is rising, prices will fall and yields will rise. What we are seeing is a dual increase in supply: US indebtedness means government issuance will continue to be heavy and quantitative tightening will add to this supply.
The pity is that I did not write about this four weeks ago. To be fair, I have talked about the change in Japanese monetary policy and the impact of government deficits on bond supply. And this is the difficulty. We can rationalise why things have happened, but trying to balance up a whole range of factors and then determine their impacts is tricky. I am paid to do this, and success is based upon getting more things right than wrong. Perhaps in time, Artificial Intelligence (AI) will replace economists and investment strategists and make better calls. I have a feeling that markets will continue to confound, although perhaps AI will be even better at offering explanations afterwards.
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