The last several years have been challenging enough for bond investors and this summer is shaping up to be more of the same, despite some hopes earlier this year for a change in fortunes. What factors have been driving this?
Over the past few years there have been quite a few new buzzwords that seem to signify the overriding theme of those distinct periods. The pandemic added terms such as ‘lockdowns’ and ‘face masks’. As we moved past the pandemic-driven widespread vaccinations, the buzzwords moved towards ‘energy’ and ‘cost-of-living crisis’. Thus, inflation became a large concern again for wider developed markets and central banks moved away from the modest moves in interest rates towards the most aggressive hiking cycle in decades. This drove bond yields sharply higher last year, resulting in one of the worst years for bond investors in living memory.
This year, investors expected the central bank medicine to start having a more profound effect, thereby cooling the economy in light of the rising cost of borrowing. Furthermore, the starting point for government bond yields was elevated relative to recent history. As such, investors expected a much more favourable return profile for bonds.
During the US regional banking crisis in March, it seemed as though this prescribed path was being met. However, the economic resilience over the second quarter and the summer so far led investors to pare back expectations of a sharper slowdown and move towards expectations of a soft landing. Inflation, at least in the US, seems to be moving closer towards the target with the headline level just over 3%. Elsewhere, inflation has started falling but the acute energy crisis on Europe’s borders means the peak was late, with prospects of more material declines for the rest of the year.
Yet, despite the improvement in inflation and some dampening in growth momentum, longer-dated bond yields have moved materially higher in recent weeks resulting in negative total returns for the US Treasury index1. The closely-watched ten-year US treasury hit its highest closing level since 2007.
Some attribute this to the future path of inflation. In essence, it was a lot easier getting inflation from 9% to levels around 3% but meeting the 2% target will be a lot more challenging. This theory has gained some traction given the changes to the supply side of the economy, potentially resulting in bouts of stronger price pressures with the tight labour market in particular focus. However, the bond market does not appear to agree. The move higher has been mostly led by real yields, rather than nominal yields. This means that inflation expectations have not materially changed, and these moves will tighten financial conditions further.
Looking at the shape of the yield curve, there might be some better explanations. While the ten- and thirty-year US Treasury yields have moved towards their cycle highs, the two-year note remains below its peak yield seen in March this year. This means that the curve inversion between two- and ten-year notes has become less extreme moving from around 1.1% toward 0.7% inverted. Perhaps this reflects the view that investors are coming more to terms with the ‘higher for longer’ narrative the Federal Reserve has been signalling. However, large moves over the summer can also point to liquidity issues. On this front, we can see some technical drags on the market.
In the wake of the debt ceiling debacle, Treasury issuance is expected to ramp up, putting pressure on the bond market.
The large deficits, compounded by an increased cost of interest servicing and rising medical bills, have raised concerns of the fiscal trajectory. It could also raise the costs for banks as deposits move into higher yielding government bonds.
The US is not alone facing these challenges, with the UK and Europe also facing higher interest burdens and the drag of an ageing population. At the same time, central banks are looking to reduce the size of their balance sheets under their respective Quantitative Tightening programs.
Further factors complicating the mix are the recent adjustments by the Bank of Japan (BoJ) and the Chinese intervention in its currency market. By slightly tweaking the way the BoJ enforces its yield curve control, it has allowed its yield curve to steepen further. As a result, it saw poor demand in its 20-year bond auction putting further strain on longer-dated bonds. It is no coincidence that longer-dated bonds elsewhere have also moved higher. The woes affecting China’s ailing property market and concerns on its shadow banking system has seen China loosen its interest rates. This has put further pressure on its currency. The Chinese authorities have moved to intervene more forcefully in the foreign exchange markets to prop up its currency. This process likely results in selling down some of its reserves, with a large proportion held in US Treasuries.
Taking it all together, the summer is notorious for markets becoming less liquid. As such, the combination of the effects above is resulting in a difficult environment for bonds. Ten-year Treasury Inflation Protected Securities hit a cycle high of near 2% earlier this week which is likely to dampen economic activity and these historically attractive levels may result in capital being pulled away from riskier assets.
Whether this difficult backdrop will result in further weakness in Treasury market over the coming weeks is hard to tell, but investors can take advantage of the higher yields on offer, particularly given an uncertain backdrop.
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