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Aon Retirement and Investment Blog

AA View: What is behind rising US Bond Yields?

Summary

  • US bond yields have risen significantly this year, though the move looks less impressive seen against the trend over many years.
  • This move is more marked at intermediate durations than long, reflecting a marked yield curve flattening.
  • We ask why yields have been rising. On a bond market fundamentals basis, rising real interest rates appear the strongest driver. Inflation expectations remain contained.
  • Bond market expectations for the level the Federal funds rate will reach by 2020 have doubled in the past year, which appears to be the single most important yield raising factor.
  • A rise in the duration premium is not to blame for higher yields. The premium remains in negative territory.
  • We also look at possible demand weakness and higher supply as causes of recent US treasury weakness. Rising currency hedging costs may deter some foreign demand, but this is not reflected in the data as of yet, and probably marginal in its impact.
  • Treasury issuance is raising supply, another possible yield-raising factor. Like demand changes, this appears rather less important than the change in interest rate expectations.   
  • Rising yields and revised expectations on policy interest rates are bringing bond markets much closer to our views on bond yields.
  • Risks to yields stay tilted to the upside though much less than before. The risks of a further very large move in yields of the 1-2% type – a bond market 'crash' – are still low. 
Treasury yields are moving up…but we need to keep perspective

US bond yields are up this year, 10-year yields currently up some 75 bps over start of year levels. This is a fair-sized move in less than a year.  That said, we need to keep perspective on the longer-term trend. After all, we could turn the observation around to say that it has taken us five years to break through levels seen some five years ago!

When we come to the long-end of the US yield curve, there is even less evidence that yields are breaking through the ranges seen over the last few years. As the chart overleaf shows, we are well short of the 2013 highs.  Given the greater importance of longer duration bond yields for typical liability matching considerations, the lack of as yet convincing evidence that yields are breaking out of the low levels/recent ranges seen for close to a decade is meaningful.  So, yes, yields are on the move, but the move is still small compared to the long-held trend of lower, or just low, yields. 



A flatter yield curve… but why?

The flattening of the yield curve as the long-end responds sluggishly to higher short-dated yields is striking. Even the 2-10 yield curve, which is much more responsive to policy interest rates than the long end of the curve, has seen a strikingly flatter trend (see chart below). While the curve is still some way short of inverting, a precursor to most US recessions, this trend clearly bears watching.  The current
buoyancy of the tax-cut stimulated US economy is failing to stir long-dated yields meaningfully yet[1]. As we have commented elsewhere, such flattening cannot be adequately explained by QE or pension plan buying. It is very likely signaling bond market caution on economic growth prospects once the tax stimulus has flowed through.

What is driving yields higher?

We want to ask why bond yields are rising. A good start is to deconstruct yields into its three components: expected inflation, real yields and a duration/term premium (to compensate for interest rate and inflation uncertainty for investors taking on duration risk). Looked at this way, it is easier to identify why yields have been on the rise.   


The first task is to look at whether it is the real or the inflation component of yields that is driving the recent move in yields. What is immediately clear is that inflation expectations are not a factor.

The bond market's inflation expectations, as measured by the so called break-even inflation rate, the difference between TIPS yields and fixed interest US treasury bonds of equivalent duration, have been stable. As the chart above shows, these are below levels seen as recently as 2012/13. Even the 10-year break-even inflation rate in the bond market, more sensitive to concerns about inflation in the next few years, is at about 2%, signaling a view that the US Federal Reserve will meet its inflation target. No worries over run-away inflation being signaled here.

It is mostly real yields that are moving nominal yields, as the table shows. Real yields, like inflation, have not moved beyond recent ranges, but they have been moving higher in a concerted way recently. Why? The answer is that the bond market has been upping its view on how much and how quickly the Federal Reserve will raise rates.

The chart below, showing expectations for the Federal Funds rate at the start of 2020 is revealing. This has moved up a great deal over the past year. The bond market was initially unwilling to accept the interest rate path that the Federal Reserve had indicated but has been revising its view. Recently, the Federal Reserve has also upped its estimates, so it is not entirely a bond market error. The move up from 1.5% to about 3% is pushing the front end of the US yield curve higher. Since inflation expectations have not risen in tandem, this is a 'real' interest rate push. The impact lessens at the far end of the yield curve, which is less sensitive to near-term policy rates.

Duration premiums are still negative

Another potential driver of rising yields is a rise in the duration premium – if long duration bond holders fret about being caught by unanticipated rises in inflation or interest rates and demand higher yields as compensation. However, the most widely used measure of the duration premium, shown in the chart below still appears negative and show no indication of rising. The message is that bond-holders are more than happy about taking duration risk. Of course, there are good reasons for the bond duration premium to be much lower than in the past when it was at a sustained and significantly positive level. Even so, the current negative levels are odd. Be that as it may, it is clear that a rising duration premium is not behind the recent rises in yields.

Weaker demand?

Away from bond market fundamentals, weaker demand could also explain higher yields. The argument is that foreign investors are being deterred from buying/holding more US treasury bonds because of rising currency hedging costs. These have been moving higher reflecting higher interest rates relative to Europe/Japan. Central bank demand for bonds is also falling globally. Alongside, the Federal Reserve's gradual balance sheet contraction makes US dollars a bit scarcer, which could be reflected in the so called cross-currency basis, a part of hedging costs reflecting the cost of currency swaps used for hedging.

Allowing for interest rate differentials and the cross-currency basis, hedge costs currently offset yield differentials for European and Japanese investors. However, investors prepared to under-hedge US dollars because of a currency view (which may be the case for many UK investors for example), or because they are looking for safety in a more uncertain market environment, may be less deterred. In any case, available data on foreign flows into US treasuries do not, as yet, show a drop-off in demand. Until it is clearly showing up in the data, it is difficult to confirm this as a cause. It could be a factor but is likely to be marginal.
   
More supply?
   
Is rising supply to blame for the recent weakness in US bonds? The US is running larger budget deficits and borrowing more as the chart below shows. The increased average monthly issuance from circa $50m to $80-$100m a month could be a factor raising yields. Like weaker foreign demand above, however, it would struggle to explain the move to any significant extent. 

What lies ahead? Our view

Let us summarize. Looking at bond fundamentals, rising inflation expectations or bond risk aversion can be ruled out as factors taking yields higher. The possibility of somewhat weaker demand and greater supply from more treasury issuance could be a factor in higher yields. However, we see the move occurring so far mainly resulting from a revised view on a steeper path and a higher level for US policy interest rates than earlier. This counts as a shift in view on 'real' interest rates. Will this continue, for how long and how strongly?

We have for some time expected yields to move further than the yield curve has implied for two reasons: first, we have seen further and faster moves in US policy interest rates than the bond market signaled, and secondly, due to a reversion to a small positive duration premium as the Federal Reserve's support to the market dwindled.

Recent rises to Fed policy rate expectations have taken market views to similar levels as our view. However, our expected move in the duration premium from negative levels to a small positive has not happened. Allowing for this and the likelihood of the bond market 'overshooting' – i.e. yields for a while going higher than what we would regard as fair value, means that the risks for yields are still to the upside for the time being.

This is not, however, portending a bond market crash. Few of the fundamental ingredients of large rises in inflation or substantially faster interest rate moves exist. Neither demand nor supply trends are sufficiently strong to bring this about.

We do see yields heading still higher over the medium-term. From here, though, it appears to be more of a 50bp-type move than it is 1-2%.

Tapan Datta is the Head of Aon’s Global Asset Allocation Team based in London.

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[1] See Quarterly Investment Outlook, July 2018
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