In Brief

• A combination of factors drove an impressive rally in global bond yields. A large proportion of the bond yield move is linked to technical factors, including unwinding short duration positioning and pension plan rebalancing into fixed income. Among the fundamental factors in play, we see the shift from the Federal Reserve, the spread of the Delta variant and the U.S. economy moving past its peak growth rate as key contributors.

• Signals from other markets sensitive to growth risks have been more stable than bond markets.  This, alongside our fundamental view on above-trend global growth, are key reasons we are comfortable maintaining a modest underweight to duration. Multi-asset portfolios remain positioned pro-risk, mostly expressed as an overweight to equities.

An impressive bond market rally — but no harbinger of recession risk

In the last month global bond markets staged an impressive rally and drove cross market price action. At the apex of the bond market rally, U.S. 10-year Treasury yields fell to an intra-day low of 1.25%, marking more than a 30 basis points (bps) move in less than a month. The gains are all the more remarkable in the face of resilient economic growth, building inflation pressure, high pace of vaccination and economic reopening. 

We’ve heard various explanations for the yield moves, ranging from technical factors on one end of the spectrum to a view that the bond market is signaling impending secular stagnation or even recession. The yield declines do not seem a harbinger of sinister economic scenarios, but we do see imprints of both of these narratives. In this report, we discuss the factors driving bond moves — technical and fundamental — and examine why our multi-asset portfolios maintain a modest underweight to duration amid a pro-risk tilt.

What started as an isolated move in the U.S. bond market quickly broadened to global bond yield curves as the spread of the Delta variant in developed market economies drew growing concern. At the same time, the June pivot from the Federal Reserve (Fed) (discussed below) added to market volatility. Essentially, the Fed’s move to safeguard inflation expectations at the exact moment investors shifted their focus to downside growth risk exacerbated the moves in bond markets and contributed to the price action. Ultimately, though, it seems clear that the majority of the move was led by a recalibration of the growth outlook amid position squaring and supply/demand imbalances.

Technical factors at forefront of bond yield moves

Yields started to fall after peaking at 1.75% in May as investors who were already short duration started to reduce those positions. As the pace of reductions accelerated, it led to buying pressure and a drive lower in bond yields. At the same time, demand for long duration bonds from asset-liability management investors picked up after Q1 as the sharp rally in equity markets prompted rebalancing into fixed income. This especially pushed up demand for the long end of the U.S. Treasury yield curve and exacerbated short covering activity.

In addition, the COVID-19 recession resulted in excess cash balances across private sector balance sheets. In particular, bank deposits rose from USD 13.4 trillion in March 2020 to over USD 17 trillion with only 65% of this offset by loan growth (vs. 80% offset via loans in early 2020). This excess cash has been recycled into securities investments where banks increased security holdings by USD 1.3 trillion with a sizeable inflow into U.S. Treasuries. This technical buying support emanating from banks is likely to continue in coming quarters as credit loan growth has yet to pick up.

Macro drivers behind the bond market rally

Three subtle changes in the economic landscape have occurred during the past month. None significantly alters our base-case expectations, but together they have shifted somewhat the distribution of likely outcomes for growth and inflation. First, Fed communication took on a more hawkish tone. Second, the spread of the coronavirus Delta variant led to renewed restrictions on mobility in several countries. Third, the U.S. economy showed signs of having moved past its peak growth rate for the current cycle.

At the conclusion of its June meeting, the Federal Open Market Committee (FOMC) published an update to its participants’ expectations for the economy and policy over the next few years. Somewhat surprisingly, projections for policy interest rates moved up noticeably without much change in inflation forecasts for 2022 and 2023. To be sure, the so-called “dots” represent only a collection of individual views, not a coordinated message from the FOMC. In our reading, though, the dots suggest that satisfying the inflation criterion for raising the policy rate may prove easier than previously believed. We do not believe the FOMC is looking for an early end to the cycle and still expect the first rate hike in the second half of 2023. But we also see a diminished possibility that the Fed will fall behind the curve and thus allow for an extended surge in inflation.

Thus far, the Delta variant is taking its toll primarily in countries that have not yet vaccinated a large share of their populations. The incidence of severe health outcomes has not risen much in core developed economies like the U.S., UK, or euro area. We doubt policymakers in these countries have much appetite for renewed lockdowns. But restrictions have tightened in several places, including Japan, Australia, and parts of Emerging Asia, likely postponing a portion of their recoveries. This smoothing-out process should do little to affect cumulative growth over the next several quarters but will help to alleviate near-term capacity pressures.

Finally, economic surprise indices for the U.S. have slipped recently, in part because expectations are already running high, but also because some indicators, such as the ISM surveys, have softened (Exhibit 2). The second quarter likely will prove to have been this year’s apex for sequential U.S. GDP growth. We see only modest implications from this deceleration, primarily because we expect the economy to continue expanding at an above-trend clip through 2022. In the short term, however, markets may be struggling to distinguish between a benign retreat from historically rapid growth and a more concerning mid-cycle slowdown that would put downward pressure on corporate earnings expectations and bond yields. 

Data momentum, as measured by changes in the Global PMIs, has moderated in the last month. At the same time, there have been fewer U.S. activity data surprises, indicating that realized data are no longer outperforming consensus expectations. Although growth indicators are moderating, we still see above-trend growth over the next few quarters, both in the U.S. and in other developed markets.

Exhibit 2: Global PMIs vs. Citi data surprises for the U.S.

Source: Bloomberg, J.P. Morgan, J.P. Morgan Asset Management; data as of June 2021. For iIllustrative purposes only. 

Other asset classes not sending the same signal as bond markets

The signals we are getting from other markets sensitive to growth risks have been more stable than bond markets. For example, high yield spreads, measured by the Bloomberg Barclays index, actually tightened over 10bps in the last month – a very reassuring indicator, one that signals neither credit quality nor recession risks. The relative stability in the VIX measure of volatility is also not giving us a signal of imminent concern. This cross-check corroborates our view that the majority of the bond yield move is linked to technical factors. 

Asset allocation implications

Just as bond yields overshot to the upside in March on inflation concerns, they may well now be overshooting on the low side due to technical factors and growth concerns. There are clearly signs that the bond market is recalibrating to slowing growth momentum after the recent run of data — but this recalibration is to a still very strong, above-trend growth environment, even if it is slower than the blistering pace of Q1 this year (Exhibit 3). At the same time, as economies re-open and labor markets heal, we expect central banks to slowly but incrementally move away from extreme policy accommodation. The Federal Reserve will likely  announce a taper of its asset purchases at the end of this year, we believe. This would be consistent with a gradual move higher in bond yields, with U.S. 10-year yields likely to rise back to the 1.5%-1.7% level.

U.S. bond yields have risen over the year. Recently, though, bond markets have been recalibrating to the new phase of growth on the horizon with both real yields and breakeven inflation rates coming down. We think the market moves reflect this recalibration, the Fed’s shift in stance to guard against right-tail inflation risks and various technical factors.  

Exhibit 3: Breakdowns bond yields – real vs. breakeven components

Source: Bloomberg, J.P. Morgan Asset Management; data as of July 2021. For iIllustrative purposes only.

Our portfolios continue to be positioned for higher equity markets on  expectations that strong economic growth translates into significant corporate earnings growth. For now we think a risk-on stance, mostly expressed as an overweight to equities, is the right way to be positioned at this stage of the business cycle. However, given the technical support for duration at the moment, and our expectations for a more constrained rise in yields (post the June FOMC meeting), it also makes sense to pare back some of our erstwhile strong preference for value and cyclical exposure within equity markets. These can and have been highly correlated with duration positioning in portfolios.

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