In Brief:

• Bond yields have failed to undergo a meaningful rally as the economic recovery has gathered steam over the course of the year, due to a multitude of factors that have weighed on yields, disconnecting them from economic fundamentals.
• Eye-popping rates of U.S. inflation in the last few months have done little to resolve the divide between investors who fear higher rates of inflation and those who don’t. Stickier inflation in the coming months and better economic data may persuade markets otherwise.
• The U.S. Federal Reserve (Fed) and other central banks have pushed back against rising yields given the focal stance on transitory inflation and a willingness to let economies run hot before considering a normalization in monetary policy. However, with tapering of QE in the U.S. fast becoming a reality, this shift in rhetoric may start to see yields rise once again.  

The accelerated decline in U.S. Treasury yields since the middle of the year appears at odds with the still strong economic fundamentals of the U.S and the global economy. The potential for a slowdown in the world’s two largest economies, China and the U.S., is feeding concerns over a peaking in global economic growth and increasing caution about an economic slowdown. The spread of the Delta variant is only adding to these concerns and supporting demand for duration. Meanwhile, the longer-term theme of secular stagnation has resurfaced as some assume that a return to the post-global financial crisis (GFC) period of weak inflation and sub-par growth rates will be the norm after the peak in growth has passed. What concerns investors the most is not whether yields will actually rise, just how far and how fast. The following outlines some of the key factors that we see leading to a sustainable move higher in government bond yields, led by U.S. Treasuries. 

Timeout: A turn in the economic data

As the initial rebound from recession passes, the economic momentum will gradually start to moderate, even if growth rates are still strong. However, the greatest reactions happen to the unexpected and markets are no different. News that changes commonly held expectations tend to set money in motion. There is a fairly close relationship between the U.S. economic surprise index and the change in U.S. Treasury yields (Exhibit 1). The steady misses in key economic data over the past few weeks have led investors to downgrade their outlook for growth, weighing on yields in the process. 

EXHIBIT 1: LACK OF POSITIVE SURPRISE HAS LOWERED YIELDS
Source: Citi, FactSet, Tullet Prebon, J.P. Morgan Asset Management.
Data reflect most recently available as of 20/08/21.

This has been particularly relevant for U.S. business surveys for the services and manufacturing sectors, such as the Institute for Supply Management and Purchasing Managers’ Index figures, and labor market data. The distortive effect of government measures to support workers is well known and the July employment report gave the first indication of how much faster the employment situation could improve in the coming months. However, market views and bond yields are unlikely to be swayed by just one month’s data and stronger (or at least less disappointing) job gains and stronger economic data more broadly is likely to be needed to reassure markets that momentum is not stalling. Similarly, a turn in the rise of Delta cases would provide more comfort about the trajectory of the U.S. economy. 

A hot hand: Inflation that doesn’t retreat

Eye-popping rates of U.S. inflation in the last few months have done little to resolve the divide between investors who fear higher rates of inflation and those who don’t. Today’s underlying pressure on prices stems from low base effects and the impact of COVID-19 disrupted supply chains, creating very large price increases in a small number of goods. In July, U.S. inflation remained above 5% year-over-year, but there were early indications that some of the culprits of higher inflation, such as used car prices, were starting to fade. The current low yield on bonds doesn’t reflect the heightened debate over the inflation outlook, but on balance it appears that market participants are buying into the transitory nature of current inflation impulses. However, the impact of disrupted supply chains and a surge in spending as mobility restrictions ease is likely to keep inflation higher in the near term, masking the ability to get a clear picture of the level of cyclical inflation in the economy. This could potentially leave bond markets less sensitive to elevated near-term inflation levels.

The key factors to watch when it comes to the persistence in inflation rates are shelter costs and wage growth. Shelter costs are one-third of the U.S. inflation basket and prices here tend to move in longer cycles than other parts of the Consumer Price Index basket (Exhibit 2). The recovery in shelter costs may generate more sustained rates of inflation even as price spikes related to the re-opening of economies (e.g. airfare, leisure and travel) start to abate. 

EXHIBIT 2: RISING SHELTER COSTS MAY CREATE MORE PERSISTENT INFLATION PRESSURES
% CHANGE Y/Y

Source: BLS, FactSet, J.P. Morgan Asset Management.
Data reflect most recently available as of 20/08/21.

Tighter labor markets should also lead to higher inflation expectations as wages rise. After the GFC, wage growth started from a very low level and was slow to catch up to the falling unemployment rate. Coming out of the pandemic-induced recession, wage growth is already relatively high and the unemployment rate is still some way off from estimated full employment. Moreover, given the healthy unemployment benefits paid to individuals in the U.S. and the difficulty many businesses have stated in finding labor of the right skill set, wage growth is likely to be a stronger force on inflation. The reservation wage, or lowest acceptable wage at which a worker will accept a new job, has been rising for over a year, spiking sharply for those in the lowest income bracket (Exhibit 3). 

EXHIBIT 3: U.S. WORKERS’ EXPECTED RESERVATION WAGE HAS RISEN SHARPLY
LOWEST WAGE ACCEPTABLE FOR A NEW JOB (USD THOUSANDS)
Source: New York Federal Reserve Survey of Consumer Expectations, J.P. Morgan Asset Management.
Data reflect most recently available as of 20/08/21.

Full court press: Clarity in central bank communication

The U.S. Federal Reserve (Fed) and other central banks have pushed back against rising yields given the focal stance on transitory inflation and a willingness to let economies run hot before considering a normalization in monetary policy. The mantra of don’t fight the Fed may have become so heavily engrained that more cohesive messaging on tighter policy is needed for the bond market to take notice.

The incrementally hawkish Federal Open Market Committee (FOMC) suggests the Fed’s average inflation targeting framework is not as tolerant of inflation as first thought, and the economy is strong enough to justify a reduction in policy support and tapering of monthly bond purchases. We expect the view to become more formal at the September meeting of the FOMC as the Fed prepares markets well ahead of time for the impending tapering beginning later in the year. The formalization of a tapering plan should lead to a repricing in bond markets with diminishing demand from the Fed and the prospect of increased supply to fund infrastructure and social initiatives in the U.S.

However, even as the Fed starts to run down its monthly bond purchases across Treasuries and mortgage-backed securities (MBS), the size of its balance sheet restricts how far bond yields may rise. In addition to quantitative easing (QE) purchases to maintain the balance sheet, the Fed must replace bonds that are maturing or MBS subject to refinancing each month. 

The existing QE arrangement means the Fed is purchasing USD 40billion in MBS each month. However, the low rates and strength in the U.S. housing market have led to an increase in mortgage re-financing and churn in the underlying MBS loans. This churn means the Fed is purchasing USD 60billion in MBS each month on top of the QE purchases to stop the balance sheet from shrinking.

Technical foul: Technical forces from headwind to tailwind

There has been a range of technical factors anchoring bond yields in the past months, such as the rebalancing by institutions after a long run in equities, unwinding of unprofitable short positions, the unexpected consequences of the run-down in the Treasury General Account (TGA) and the fact that the USD 28.5trillion debt ceiling has been reached. The Treasury has been running down the TGA to finance government spending initiatives instead of issuing new debt to create some fiscal space before hitting the debt ceiling limit. This acted like de-facto QE by reducing the supply of short-dated Treasuries even as demand remained persistent.

However, none of these are likely to hold down yields permanently. Short positions in Treasuries have unwound and may actually rise again. Meanwhile, a resolution that either raises or temporarily suspends the debt ceiling is likely to come in the coming months, easing pressure on the supply of Treasuries. A simple summary of these factors is that the supply of Treasuries has been restricted as demand has remained persistent. Lifting the debt ceiling is likely to see supply once again run above Fed demand. 

EXHIBIT 4: THE TREASURY GENERAL ACCOUNT HAS FALLEN FROM ELEVATED LEVELS
USD BILLIONS

Source: FactSet, Federal Reserve, J.P. Morgan Asset Management.
Data reflect most recently available as of 20/08/21.

Investment implication

Government bond yields are likely to rise in line with the economic expansion and as the Fed and other central banks shift toward normalization in monetary policy. The rise in yields from the lower starting point implies yields ending the year lower than what was expected just a few months ago, or that they only match the highs reached back in March.

The pace of change in yields is unlikely to come in the form of a massive and abrupt shift but rather a slow realization that economic momentum in the U.S. remains robust while other economies are still replacing lost output from the pandemic. Meanwhile, inflation may prove stickier and fiscal policy support more persistent.

There is a risk that a more proactive Fed that becomes far less tolerant of inflation could actually temper bond yields if it mutes inflation expectations. In this scenario, higher yields may not lead to a greatly steeper yield curve but rather a shifting up in the curve as shorter-dated bonds adjust for earlier rate hikes.

Our expectation is that U.S. Treasury yields are likely to rise into year-end and continue higher in 2022, creating a challenging environment to generate returns in fixed income due to duration risk and relatively expensive valuations. This can be addressed in three ways. First, investors will need to look for fixed income assets with short duration, or low sensitivity to rising rates. Second, high yield bonds, either U.S. corporate high yield debt or emerging market fixed income, can help to generate much-needed returns from the relatively higher coupons. Finally, investors can consider alternative assets, such as real estate or infrastructure, which generate high levels of income and have a low correlation to equities, adding to portfolio diversification. 

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