Fundamentals

Our most recent quarterly investment outlook called for higher US yields over the balance of the year. This view has been challenged recently as yields have moved lower. The abundance of bearish catalysts for government bonds that drove yields higher in the first quarter have faded, to be replaced by concerns that the economic rebound has already witnessed its peak in growth. While we agree that growth has likely peaked, we do still expect solid growth ahead, especially with the consumer on a strong footing and consumption accounting for approximately 68% of US GDP. Chase consumer data not only points to higher bank balances, but also higher spending than pre-pandemic levels driven largely by discretionary categories. The other risk the market is battling with, and the one we are most concerned about, is the spread of the Delta variant. Given its transmissibility, it seems likely that Covid cases will continue to rise sharply around the world. However, the knock-on effects will vary depending on the progress of vaccinations. The key question that remains unanswered is whether vaccinations have weakened the link between cases and hospitalisations enough to avoid significant new mobility restrictions. Early data from the UK suggests this may be the case.

Quantitative valuations

US yields have veered off the upward path that was laid out in the first quarter of this year, such that 10-year nominal and real yields now lie at just 1.22% and -1.05% respectively. With inflation breakevens capped by the Federal Reserve’s pivot at its June meeting, the recent rally seems to be mainly driven by real yields. However, we find the fall in real yields hard to justify. Many commentators have explained the fall as a return to secular stagnation, but we have learned little about where the economy will be in five years’ time in the past few months, and this explanation seems more like fitting a narrative to flow-driven price action. Our expectation of where the Fed Funds rate will end up in this cycle remains in the 1.75%-2.50% terminal range that was witnessed in the last cycle, which is roughly a zero real rate. However, we will only learn how much tightening the economy can take as we go through the cycle. (Data as of 20 July 2021).

US nominal and real yields are firmly off track but we think they will start increasing again

Source: Bloomberg; data as of 20 July 2021.

Technicals

While we can’t entirely attribute the move lower in US government bond yields over the past couple of months to positioning, it has certainly played a role in exacerbating the rally. Futures-based positioning metrics have shown investors adding duration, but survey-based measures have not yet shown the cleanup in positions to the same extent. Overall, though, the weight of consistent bond buying, from both central banks and the private sector, seems to have made its mark. Summer seasonality typically also favours bullish duration as bond supply tends to subside in the summer months. This summer, the drop in supply has happened sooner than usual.