Bonds: Shaken, not stirred

Yields on government bonds led by US Treasuries have shot up on a potent cocktail of a firming economic recovery combined with risks of higher inflation. The 30-year US Treasury real yield is now in positive territory for the first time since June 2020, while the 10-year nominal yield has risen 50 basis points in the year to date.

If bond yields rise, their values fall, making them less attractive for investors and more difficult for governments to sell to fund their spending packages. This raises the risk of some kind of central bank intervention to protect the fragile recovery from the pandemic, says strategist Peter van der Welle.

“We think that the recent upward move in yields has further to run over the coming months, though the pace of it could be slowing,” he says. “In the early phases of economic expansion, bond investors typically start to demand a higher yield to compensate for rising economic growth. While the current recovery remains uneven, green shoots have been appearing almost everywhere in the global manufacturing sector.”

“Along with a firming economic recovery in manufacturing, services sector producer confidence should pick up as well once economies start to emerge from lockdowns. As services activity represents the largest chunk of economic activity in developed economies, positive surprises in services sector data as economies reopen will likely sustain pressure on real yields.”

The 32 basis point increase in the real yield of the benchmark 10-year Treasury in the year to date has largely coincided with continuing positive macro surprises. This stands in sharp contrast with 2013, when real yields significantly overshot underlying macro surprises after the US Federal Reserve said it would reduce its QE program. This promoted real yields to skyrocket from -75 bps in April 2013 to +90 bps in September, five times the size of the move observed so far in 2021.

“The current alignment of recent moves in real yields with macro surprises therefore seems to be more growth related rather than inspired by central bank tightening fears,” says Van der Welle. “Recent sell-offs in the belly of the yield curve do reflect higher expectations of Fed tightening, but these have remained fairly modest.”

“The absence of an overshoot in real yields compared to what is warranted from underlying growth momentum suggests that central bankers have not lost control of the curve. This explains why Fed Chairman Jerome Powell and other officials have remained relatively tolerant of the recent steepening.”

“Furthermore, what is perhaps reassuring central bankers is that the ongoing steepening is not out of step with historical steepening episodes previously seen during the early expansion phase of the business cycle.”

Aside from cyclical factors, US bond investors are demanding additional compensation for inflation risks in an economy that is facing unprecedented levels of monetary and fiscal stimulus. The US is about to deliver a USD 1.9 trillion relief package in Covid-19 stimulus cheques, while Congress is also considering a USD 1.3 trillion 10-year infrastructure plan.

“There is a lively debate among economists about whether delivered and forthcoming stimulus occurring in conjunction with the release of excess household savings could close the US output gap already this year, creating overheating,” says Jeroen Blokland, head of the multi-asset team.

“With various indices already hinting at supply side pressures, inflation could prove to be more persistent as economies reopen over the coming months. In this setting, the repricing of inflation risks is likely not over, even as the required inflation risk premium in the bond market has shot above its historical average.”

Central banks have been closely monitoring developments, but the Fed has not yet pushed back against yield rises. “Though the bond market is shaken, the Fed has not stirred it through verbal interventions or concrete action,” says Blokland. “The Fed seems to feel comfortable with the current mix of factors contributing to the steepening of the curve.”

“It could remain in the wait-and-see mode as long as ongoing dynamics sustain real economy activity momentum, and progress is made towards the intended inflation overshoot that would correct the 0.5% core PCE undershoot during the previous expansion.”

“Meanwhile, this reluctance from the Fed is starting to contrast with the guidance given by the European Central Bank and the Bank of England, who have hinted at intervening if the bond yield rise threatens market liquidity conditions and the recovery trajectory.”

Van der Welle says there is also the possibility of a ’shaken and stirred’ scenario for the bond market. “Monetary policymakers could judge that real yield levels are hampering the economic recovery as well as liquidity conditions, prompting them to jump into action by extending bond purchases, or hinting at announcing them,” he says.

“The ECB has been the most vocal in stating that the steepening in the yield curve we have seen is unwelcome and should be resisted, with some ECB officials hinting at increasing the volume of asset purchases if needed.”

“Overall, we think the recent rise in yields has somewhat further to run.”