2021 is shaping up to be a difficult year for investors in fixed interest securities. The iShares global government bond ETF is currently down nearly 5% since the end of 20201, as yields have risen (a bond’s price moves inversely with its yield). The run-up in yields has been led by the US, where the 10-year benchmark Treasury yield is currently trading at 1.6%, up from 0.9% at the end of last year2. Given the international nature of the bond market and the influential role of the US economy, yields in other markets have also drifted higher3 .
What has caused government bond yields to rise?
A number of economic factors can influence yields. As a ‘safe-haven’ asset, the yield on a government bond essentially reflects investor sentiment about the economic outlook. More specifically, higher expectations for economic growth, inflation and interest rates will tend to cause yields to rise, and vice versa. These factors are obviously interrelated, and all three have played a role in driving yields higher in recent months.
Take economic growth first. Forecasts for economic growth in 2021 have been revised up in recent months on the back of two factors: the successful rollout of Covid-19 vaccination programmes, and US fiscal stimulus that has been larger than most observers had initially expected.
Although there have been issues with the rollout of vaccines in continental Europe, vaccination programmes in the US and the UK are going well, encouraging hopes that economies can reopen and activity can return to normal during the second half of the year. In the US, coronavirus infections, hospitalisations and deaths have fallen sharply 4, and President Joe Biden has said that all adults would be eligible for a vaccine by 1st May. As economies reopen, the expectation is that pent-up consumer demand will be released, as households spend the excess savings that were built up during lockdowns.
The package of measures included in the “American Rescue Plan” will add fuel to this ‘reopening recovery’. At the start of the year, most observers had expected President Biden’s proposed fiscal stimulus to be watered down in order to gain congressional approval. However, with the Democrats able to override Republican opposition by using a parliamentary procedure known as ‘reconciliation’ to secure its passage, the US$1.9 trillion stimulus bill was signed into law on 11th March virtually unscathed5.
The plan – which includes stimulus cheques of US$1400 for most Americans, unemployment benefit top-ups/extensions, increased child tax credits, and funding for schools, businesses and local governments – comes on top of the US$900 billion covid relief bill passed in December6. This amounts to a big injection of cash into the economy; the combined scope of both bills, US$2.8 trillion, equates to around 13% of GDP7.
Against the backdrop of such a large increase in debt-funded government spending, it is not surprising that expectations for growth have been revised up. In its latest Economic Outlook publication, the Organisation for Economic Cooperation and Development (OECD) nearly doubled its forecast for 2021 US GDP growth to 6.5% from the 3.2% it had pencilled in last December8. Given positive spillover effects to America’s trading partners, the OECD reckon the Biden stimulus could add more than a percentage point to global growth, which it now sees at 5.6% in 2021, up from the 4.2% expected in December.
In turn, a faster pace of growth is expected to put upward pressure on inflation. According to the OECD’s modelling, the Biden stimulus could increase US inflation by 0.75 percentage points per year on average in the first two years following its introduction9. Importantly, this uplift comes at a time when there are already signs of cost pressures building in the economy. A transitory increase in headline inflation in 2021 had always been on the cards, as the sharp fall in energy prices witnessed in early-2020 falls out of annual comparisons10.
However, recent survey data points to the possibility of broader price pressures, as a surge in demand comes up against supply chains which, in some sectors, have been impaired by pandemic-related disruption. Prices for commodities, including copper, oil and food stuffs have risen sharply in recent months, with the Bloomberg commodity price index recently hitting an 8-year high11. Moreover, the February global PMI survey showed companies’ input costs rising at the fastest pace in over 12 years and reported that upward price pressures were spreading from basic manufacturing sectors through to consumer goods and services, hinting at broad-based inflationary pressures12.
This is significant, as during the pandemic, core inflation (currently well below 2%13) has been held down by low levels of service sector inflation, as demand for hotel rooms, flights and hospitality plunged. For example, February’s CPI report showed the cost of staying in a hotel room down 15% from a year earlier14. However, as the economy reopens, demand for services is likely to surge, and with businesses keen to boost margins and make up for revenues lost during the pandemic, prices could rise sharply. Indeed, the latest survey from the National Federation of Independent Business (NFIB) showed the proportion of small businesses planning to raise prices at its highest level since 200815. Rents and other measures of accommodation costs are also likely to pick up following recent strong gains in house prices16.
Given rising cost pressures and the prospect of stronger economic growth, bond markets have moved to price in higher inflation. Market expectations for annual average inflation during the next 5 years (the so-called 5-year breakeven inflation rate) currently stand at 2.5%17, up from around 2.0% at the beginning of the year. However, it would appear that market participants anticipate that the burst of above-2% inflation will be short-lived. Expectations for inflation during the subsequent 5-year period (i.e. 2026 to 2030) are for an average of just 2%18.
Increased rate expectations
This might reflect the notion that the boost from fiscal stimulus and a post-pandemic spending splurge will be transient. However, it is also consistent with the idea that tighter monetary policy from the US central bank, the Federal Reserve (the Fed), will ultimately bear down on inflation following a temporary spike. Indeed, investors’ expectations for the timing of Fed interest rate hikes have been brought forward in recent weeks; the market is now fully pricing in an increase of 25 basis points (a basis point is 100th of a percentage point) in the Fed’s policy interest rate by March 202319. This pricing is at odds with current guidance from the Fed20, which has indicated that it will keep interest rates unchanged at close to zero until 2024 in order to foster a moderate overshoot of its 2% inflation target to compensate for earlier undershoots (see our Commentary of September 2020).
Given that higher government bond yields threaten to tighten financial conditions via their knock-on impact on private sector borrowing costs (e.g., mortgage rates, corporate bond yields etc.), a key question going forward is whether the Fed will follow the Reserve Bank of Australia (RBA) and the European Central Bank (ECB) in pushing back against the recent rise in yields. Both the RBA and the ECB have recently announced an increase in bond purchases in a bid to push up bond prices and reduce yields21,22. So far, the Fed has been more relaxed about rising yields, although Fed Chairman Jerome Powell has hinted that action might be forthcoming if market conditions become ‘disorderly’23. Investors will be watching keenly for any new guidance from the Fed when it concludes its 2-day policy meeting on 17th March.
Despite the possibility of central bank intervention and potentially even a move towards a policy of ‘yield curve control’ akin to that currently pursued by the Bank of Japan, there is still scope for yields to rise further due to a combination of higher expectations for growth, inflation and interest rates. Nominal yields are still below pre-pandemic levels24 and ‘real’ yields (i.e., after accounting for expected inflation) are still negative25. This appears out of line with post-pandemic economic prospects. Looking beyond this year’s ‘reopening recovery’, President Biden’s plans for increased infrastructure spending26, if passed by congress, could come to fruition just as the economy is reaching full employment, compounding concerns about overheating. The hard times for bond investors seem unlikely to end anytime soon, and better opportunities exist in parts of the equity market that will benefit from stronger economic growth.
16th March 2021