CIO view: Bond yields – why so low?
US Treasury yields continue to fall with the benchmark 10-year yield dropping below 1.2% at the start of August, to trade at around 1.16%.i
In contrast, at the end of March, yields hit their high point for the year at 1.7%. The US Treasury yield curve has flattened, and other developed market bond yields have also fallen. It appears that the bond bear market that many predicted at the beginning of the year has been, at the very least, delayed.
But there is no end of macroeconomic reasons why bond yields should be higher. Inflation has increased in most developed markets; growth is above trend as economies recover from the impact of the pandemic in 2020 and government borrowing has risen in the wake of pandemic emergency programmes designed to support household and corporate incomes.
However central banks must be closer to the end of what we can broadly call zero interest rate policies. So far, none of these macro factors have sustained the increase in yields we saw in the first quarter. But nonetheless, higher yields are still forecast. These predictions are justified given expectations that the Federal Reserve will announce asset purchase tapering towards the end of the year - or a more persistent increase in inflation evidenced by some instances of wage growth and ongoing supply bottlenecks.
But right now, the market does not reflect this way of economic thinking. For investors, being ‘short’ rates has meant underperforming a 3.4% total return in a broad Treasury bond index between the end of March and the end of July.
Through our MVST (macro, valuations, sentiment and technical) framework, we pay attention to other influences on market pricing. The macro story has been clear and even if the growth outlook gets a little hazy from time to time, with the rise in COVID-19 Delta variant infections being the most recent reason for this, it’s hard to explain the 60 basis point decline in yields on the back of a radically changed growth outlook. Moreover, inflation has been rising all that time.
The explanation for lower yields most likely relies on an understanding of the technical factors underpinning the relative demand and supply story for US Treasury securities. The main points here are:
- Ongoing QE: The Fed is buying $80bn of Treasury securities each month. In 2021 it increased its holdings by $567bn (to the end of July). The Fed owns around 22% of outstanding Treasury debt. For now, it is continuing to increase its holdings until it decides when to start tapering its bond purchases. The flow and the stock arguments can both be used to rationalise the impact quantitative easing (QE) has had on yields.ii
- US banks: Since the start of the pandemic there has been huge growth in bank deposits in the US coming from fiscal stimulus and credit creation. A rise in deposits is an increase in liabilities for banks. On the asset side, loan growth has not kept pace, so banks have had to increase their holdings of other assets and Treasury securities are an important safe asset to meet this need. Large domestic US banks increased their Treasury holdings by $312bn in the year to the end of June. So, combined with the Fed this is $880bn of Treasury buying.iii
- Supply and demand: The US Treasury has increased its borrowing because of the rise in the budget deficit due to the aggressive fiscal policy. Yet net debt has only increased by some $758bn so far in 2021. The combination of US Fed and US bank buying has been more than the net issuance from the US Treasury.iv
- Investors: US pension funds, insurance companies and overseas investors continue to have a need for long-duration assets. A feature of many insurance businesses has been a duration gap between their assets and liabilities, sustaining a demand for long duration assets. Higher yields in the US, even when hedged back to euro and other currencies, has attracted foreign institutional investors to US Treasuries.
These technical factors are complex, and it is impossible to judge when they will become less important for the market. It is probably wise to assume that they will continue to have a dominating role. So, if yields are to rise, a few things need to happen. First the Fed would need to announce its intention to taper and reduce its net purchases of Treasuries. However, it is not likely to go from $80bn a month to zero overnight. The tapering will be spread out, but it will certainly change the dynamics in the market.
Second, deposit growth in the banking sector might slow, and banks may see increased demand for loans. Together that could reduce banks’ demand for Treasuries. And finally, inflation may prove more persistent than anticipated. The breakeven inflation rates in the inflation-protected Treasury market are at 2.4% over the medium term. That would be a comfortable level for the Fed. Any rapid increase in these inflationary expectations would bring forward tightening and would necessitate higher nominal yields. Note also that real yields are extremely negative (-1.1%) and are only likely to rise when the Fed does raise interest rates.
Globally we remain in a period of low long-term yields, largely because of the actions of central banks. The holdings of government bonds by central banks are a significant share of outstanding debt (up to 45% in the case of Japan) and this has created a scarcity value. Yes, yields don’t reflect the macro situation. If they did, they would be much higher. Yet QE and the huge creation of central bank reserves that has accompanied it has distorted bond markets so that only very real changes in the monetary policy stance – such as the Fed’s tightening between 2016 and 2019 - seems to be able to sustain a rise in yields.
Many market participants are looking for yields to rise again into year-end. But I would not discount the scenario of a sub-1% yield before then. As such I believe the total return boost to aggregate, credit and emerging market bond strategies could potentially be robust under such a scenario.
- Source for all mentioned performance data: AXA IM / Bloomberg as at w/c 2 August 2021 unless otherwise stated
- Federal Reserve
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