3 min read
Bond market blues
Government bonds rallied hard last year in response to the economic uncertainty associated with the coronavirus pandemic. However, as confidence has built in the economic recovery, yields have backed up. Should we be concerned about the potential impact on the economy resulting from higher borrowing costs? What are higher yields telling us about inflation expectations? And will bond yields continue to move higher?
Recent experience in an historical context
10-year Treasury yields and moves of at least 100bps
Focusing on the green rectangle on the right of the chart which represent the yield range (shaded) and the average yield (solid line) between the middle of 2011 and the beginning of last year immediately prior to the crisis. As the uncertainty has faded the T10 yield has returned to the lower end of its prior range. A second point to note is how recent increase in yields has been accompanied by a similar and coincident increase in CPI inflation. The third point to note relates to the size and speed of the move. The average yield reversal from bottom to top over the previous 12 episodes was 1.59% and took 234 days. The most recent episode has seen the T10 yield rise by 1.21% over a period of 227 days, which looks unexceptional both in terms of size and time.
Potential economic impact
There are two primary factors to consider with regard to the economic impact. First real yields – nominal yields less inflation - remain firmly negative, despite the recent increase in nominal yields. This implies that borrowing remains very cheap, something that is supportive of economic activity. Furthermore, because longer dated bonds have sold off as the short end has remained well anchored, the yield curve has steepened meaningfully since the middle of last year. As has been well established in the economic literature, a steep curve is a positive and reliable signal for growth over the following 12 months.
Debt service costs
Another fear that investors have is that borrowing costs are going to rise sharply as a result of higher yields and that this will create stress in debt markets. However, debt servicing costs remain well contained in the US, suggesting the economy can withstand a significant rise without causing stress. Affordability is also reflected in credit markets by virtue of the fact that spreads remain tight, both in investment grade and high yield debt. Whilst some sectors will undoubtedly experience coronavirus related challenges over the next few months, there is no evidence that the problems are economy wide.
The term premium is the additional amount investors require to be compensated for that uncertainty. Various methods have evolved for estimating government bond term premia. One that has become popular over recent years is known as the ACM term premium1.
The above chart shows the T10 yield (orange line), the ACM term premia (dark blue line) and the risk-neutral yield (green line). The entirety of the move higher in the T10 yield is due to an increase in the ACM risk premia - the risk neutral yield has declined marginally over the period since the T10 yield has reversed. The implication is that, according to this methodology, market expectations of interest rates have fallen a little, an observation that fits with the dovish messages emanating from the Federal Reserve.
Overall, the move looks to be more about normalisation after the unique situation of the past year rather than anything more sinister. If that normalisation continues and the pre-covid range serves as a good guide, it is possible that yields will rise further. However, such a move should not be confused with an increase in market fears about inflation not should it be seen by itself as something that is damaging to US economic prospects.
1 “Pricing the Term Structure with Linear Regressions” by Tobias Adrian, Richard K Crump and Emanuel Moench, Federal Reserve Staff Report No. 340.
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