Core government bond yields look expensive and maintaining a modest short in duration seems appropriate given the expectation for rising yields.
Global Market Strategist
Capital markets do not always behave as expected, as evidenced by the decline in core government bond yields in recent weeks, and the flattening yield curves that have caught many investors off-guard as they send bearish signals for risk assets. However, the decline in yields seem at odds with the booming levels of inflation and above-trend economic growth in many parts of the world. Below we outline the factors likely to have contributed to the surprising move in bond yields in recent weeks:
- Rising COVID-19 cases. The biggest risk to the outlook for the second half of the year is that a rising number of COVID-19 cases short-circuits the economic recovery. Increasing case numbers are being met with stricter mobility restrictions in Japan and certain European economies. A high rate of vaccination remains the key to breaking the link between case numbers and economic restrictions. The positive news is that vaccine supply is increasing and so far, at least, evidence suggests that the existing suite of vaccines are effective against the rising Delta variant in reducing hospitalization and fatality rates.
- Passing the peak in the economic rebound. The potential for another COVID-19 wave comes at a time when the surge in activity from the economic reopening in the U.S. looks to be peaking. Business surveys such as the Purchasing Managers’ Indices and the Institute for Supply Management index for both manufacturing and services disappointed in June. Further dampening the growth outlook may be the retrenchment in fiscal stimulus from Washington and the inability to deliver on lofty infrastructure spending plans. While it is true that the initial economic surge has passed, the economy is still likely to run at an above-trend pace of growth based on consumer and corporate spending plans.
- Tempered inflation fears. Bond yields surged earlier in the year as bond markets repriced for higher rates of inflation. While yields have been trending downwards since peaking in March, they took another leg downward following the U.S. Federal Reserve (Fed) June meeting. The shifting narrative from the Fed on the potential for earlier rate hikes and how strictly they would adhere to their average inflation targeting framework may have led to the bond market adopting a more pessimistic view of the economy, and believing that even the distant rate hikes would be too much for the economy and weigh on economic growth and inflation in the long run. The result of the unwinding in inflation expectations was a decline in the breakeven component of the nominal 10-year U.S. yield (Exhibit 1).
EXHIBIT 1: U.S. 10-YEAR TREASURY YIELD
NOMINAL AND REAL YIELD COMPOSITION
- Technical forces. Technical factors such as repositioning portfolios after a strong run in equity markets as well as covering of short duration positions ahead of, and following the June Fed meeting will have also played a role. An additional, if somewhat accidental, technical anchor on yields may have come from the decline in the Treasury General Account (TGA). The TGA can be likened to a retail checking account used to receive money and pay bills. The TGA normally operates with a balance of around USD 400billion but ballooned to USD 1.8trillion earlier in the year. To bring the TGA balance back to the normal operating level, the U.S. government has been using these funds to finance some of the existing fiscal stimulus measures. These funds eventually find their way into the banking system, whereby banks would purchase short duration assets to offset any rise in deposits. However, given the very low rate levels on shorter maturity bonds, financial institutions may have been buying bonds further along the yield curve adding to the curve flattening.
A confluence of both fundamental and technical factors has led to a decline in government bond yields and flattening of the yield curve, which appears at odds with our current position in the U.S. economic cycle and the still-robust outlook for growth. We expect that many of these factors, such as investor repositioning, will fade and that greater clarity on the inflation outlook will once again lead to a rise in longer-dated bond yields over the rest of this year. While recognizing the two-sided risk to the inflation outlook, our view is that the U.S. inflation may be stickier than currently appreciated given the potential for further fiscal stimulus, the improving labor market and above-trend growth expected in the coming year.
Core government bond yields look expensive and maintaining a modest short in duration seems appropriate given the expectation for rising yields. The strength in the economy bodes well for broader credit markets, but given the tightness in spreads in both investment grade bonds and high yield debt, returns will be much more moderate and driven by coupons rather than price appreciation. For those seeking the income and diversification benefits of government bonds, alternative assets are a worthy consideration for higher levels of income and a low correlation to equity markets, ranging from more liquid strategies like global macro style strategies to the more illiquid real assets of infrastructure and real estate.