The fixed income markets have been a key focus for global investors in recent months, as the yields on US Treasury bonds – debt issued by the US government – have risen sharply. The yield on the 10-year US bond rose around 60 basis points in September, and hit a 16-year high of 4.8% in early October before falling back somewhat1. The move higher has been most evident in longer-term yields, causing the so-called yield curve (a line which plots the yields of bonds against the length of time they have to run to maturity) to steepen2. Furthermore, the rise in yields has been driven by an increase in the ‘real’ yield (as opposed to inflation expectations), which at the 10-year maturity currently stands at around 2.4% - the highest level since 20073.
This is a big deal. As the yields on US government bonds provide a benchmark for borrowing costs in other markets, rising rates on US Treasuries usually translate to higher borrowing costs for businesses and households. Indeed, with the market in US government debt the largest in the world, it plays a key role in setting the tone for the global bond market; higher long-term borrowing costs for the US government will often result in higher long-term rates for borrowers in other countries. By way of example, even though the Bank of England left its policy interest rate unchanged at 5.25% in September, rising bond yields in the US helped drive the yield on the UK 30-year Gilt to a 25-year high of 5.1% at the beginning of October4. In short, what happens in US debt markets has big repercussions around the globe.
What has driven the rise in bond yields?
The yield of a bond moves inversely with its price; a rise in the yield implies a lower price for the bond. The price/yield of a bond is determined by supply and demand, which in turn can be influenced by a range of factors, including investor expectations for interest rates, inflation and economic growth.
Bond analysts cite a confluence of forces that have contributed to higher yields in recent months.
Firstly, the US economy has generally proved to be stronger than many observers were expecting at the start of the year. Economic data has mostly come in higher than investors expected, and the labour market has remained historically tight. As a result, consensus growth forecasts, which at the beginning of the year anticipated that the US economy would slip into recession sometime in 2023, have been revised up. In turn, this has caused the market to price out some of the cuts in interest rates that had previously been penciled in, putting upward pressure on bond yields.
The notion that interest rates will stay higher for longer has been compounded by signaling from the Federal Reserve (the Fed). The September median forecast of members on the US central bank’s policymaking committee anticipated a policy interest rate of 5.1% by the end of 2024, up from the 4.6% projection made in June5. Fed officials have indicated that interest rates will have to stay high for ‘some time’6 and there has also been speculation that the neutral rate of interest (the rate at which policy is neither restrictive nor accommodative) could be somewhat higher than the Fed’s current 2.5% estimate7.
Supply and demand
Looking through the prism of supply and demand, heavy issuance of government bonds, along with the withdrawal of several ‘price insensitive’ buyers from the market, will also have put upward pressure on long-term bond yields. Regarding the latter, having previously bought bonds under its various quantitative easing (QE) programmes since the great financial crisis, the Fed is now running down its stock of US Treasuries. Under its current schedule, the Fed is reducing its holdings of US government debt by up to US$60 billion per month by not replacing bonds as they mature. From its peak in June 2022, the US Fed’s stash of US Treasury bonds has dropped by around US$840 billion8.
Similarly, other entities that have previously bought bonds without much regard to their actual attractiveness as an investment are also reducing exposure. Notably, figures for July showed that China’s holdings of US Treasuries dropped to US$821.8 billion, the lowest since May 20099. Reports suggest that, with the Chinese currency, the Yuan, under pressure, Beijing may have sold US Treasuries recently in order to prop up its exchange rate against the US dollar.
At the same time that demand from some ‘price insensitive’ buyers of US government bonds is falling, the supply of bonds is increasing as a result of large budget deficits, which have been pushed up by falling tax revenues10. Moreover, the deterioration in the US fiscal outlook has been brought to the fore by the recent debt ceiling debacle (see our commentary of June 2023) and the subsequent downgrade of the US government’s debt rating from AAA to AA+ by the ratings agency Fitch at the beginning of August11.
According to the latest estimates from the International Monetary Fund (IMF), the US will run a budget deficit of 8.2% of GDP in 2023, up from 3.7% of GDP in 2022. Moreover, the budget shortfall is not seen falling much in 2024 and 2025, staying at 7.4% of GDP. Deficits of this size are historically high outside of periods of wartime (or most recently the pandemic) and recessions (when tax revenues fall and rising unemployment results in higher spending on welfare).
Higher deficits mean that private investors are having to digest a lot more supply of bonds. According to estimates from Schroders, when reduced demand from the Fed is taken into consideration, investors will be asked to buy a net US$2,730 billion of Treasury bonds over the coming year, about 10% of GDP and 50% higher than in the previous year. Looked at from a supply-demand perspective, the recent rise in yields might be seen as necessary to coax more ‘price sensitive’ buyers into increasing their allocation to bonds.
What now?
More recently, longer term bond yields have fallen following the outbreak of hostilities in the Middle East, encouraging some observers to speculate that yields might be peaking. However, the outlook remains highly uncertain.
The decline in yields during the second week of October appears to have had two causal factors. First, the outbreak of hostilities between Israel and Hamas probably produced some safe-haven buying of US government bonds, an asset which, along with gold, investors often flock to during times of geopolitical turmoil. Going forward, the impact on bond yields from the conflict is not clearcut. An escalation of military action could see safe-haven flows increase. However, if the price of oil spikes due to a broadening of hostilities and disruptions to supply, this could potentially put upward pressure on bond yields as a result of higher inflation expectations.
The other key driver of bond market sentiment recently has been comments from Fed officials suggesting that the tightening in financial conditions resulting from higher bond yields might negate the need for further interest rate hikes12. Such interventions from the likes of Fed Vice Chair Philip Jefferson and Dallas Fed President Lorie Logan suggest that, while the central bank is keen to see economic activity slow down in order to cool inflation pressures, it is also wary of policy becoming so restrictive that it damages the economy and sparks a period of financial instability.
The Fed will be sensitive to the fact that losses on bond portfolios (due to rising yields) were instrumental in the collapse of Silicon Valley Bank (SVB) and two other small and mid-sized US banks back in March. Higher yields threaten to further raise unrealised losses on banks’ bond holdings, and could pressure other corners of the financial architecture. In addition, higher borrowing costs present a headwind to corporate profits, while also pressuring equity valuations, raising the risk of stock market volatility.
Indeed, a concern amongst investors is that bond yields can only rise so far before “something breaks”, the Fed pivots to a more dovish bias, and bond yields fall back again. Recent comments by some Fed officials might suggest that we are approaching such a threshold, and some observers are sceptical we can see the yield on the 10-year US bond rise much above 5% before it starts to cause problems13.
Softer economic data could also cause yields to ease back. Although US growth during the third quarter appears to have been strong, it has in part been boosted by one-off factors such as the sell-out concert tours of Taylor Swift and Beyoncé, and the release of two blockbuster movies, Barbie and Oppenheimer14. Some payback following these events, along with the resumption of student loan repayments (see our commentary of June 2023) and depleted excess savings balances suggest that activity will slow during the final quarter of the year. Looking further ahead, the risk of a recession during the next 12 months still remains substantial (see our commentary of September 2023).
Peak in sight?
Of course, it is impossible to say that the highs in long-term bond yields are now behind us. Renewed upside inflation surprises could see yields drift up again, and the potential for an upshift in ‘structural inflation’ pressures (see our commentary of February 2023) suggests that yields will probably trade in a higher range than witnessed during the last decade. Moreover, the combination of ongoing quantitative tightening and increased supply of government paper are likely to work against a sharp fall in yields.
This said, signs that developed market central banks are nearing the end of their rate hike cycles suggest that longer-term yields could also be close to peaking. History suggests that the 10-year US bond yield tends to fall during the 12 months after the last Fed rate hike15. With real yields at their highest in over a decade, government bonds now offer the prospect of inflation-beating returns and portfolio diversification in the event that economies turn down and/or equity market volatility increases. For buy and hold investors, the risk-reward profile offered by the asset class has not been as favourable for quite some time.
17 October 2023
1 https://fred.stlouisfed.org/series/DGS10
2 https://fred.stlouisfed.org/series/T10Y2Y
3 https://www.cnbc.com/quotes/US10YTIP
4 https://www.reuters.com/markets/rates-bonds/uk-30-year-yield-hits-highest-since-1998-global-bond-rout-2023-10-04/
5 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230920.pdf
6 https://www.reuters.com/markets/rates-bonds/feds-bowman-expects-it-be-appropriate-raise-rates-further-2023-10-02/
7 https://www.bloomberg.com/news/articles/2023-10-11/daly-brings-higher-r-star-fears-back-into-mix-for-bond-traders?sref=QJEHVNWR
8 https://fred.stlouisfed.org/series/TREAST
9 https://www.reuters.com/markets/us/foreign-holdings-us-treasuries-increase-july-china-holdings-plunge-data-2023-09-18/
10 https://bipartisanpolicy.org/report/deficit-tracker/
11 https://www.fitchratings.com/research/sovereigns/fitch-downgrades-united-states-long-term-ratings-to-aa-from-aaa-outlook-stable-01-08-2023
12 https://www.reuters.com/markets/us/nodding-rising-bond-yields-feds-jefferson-says-can-proceed-carefully-2023-10-09/
13 https://www.bloomberg.com/news/articles/2023-10-04/five-charts-showing-how-5-us-yield-would-roil-global-markets?sref=QJEHVNWR
14 https://www.bloomberg.com/news/articles/2023-08-24/taylor-swift-led-summer-seen-adding-8-5-billion-to-us-growth?sref=QJEHVNWR
15 https://www.truist.com/content/dam/truist-bank/us/en/documents/article/wealth/insights/2023/market-navigator-october-2023.pdf