Key Takeaways
- Ten-year government bond yields stand at around 4.5% in the US and UK – a level that reflects current central bank policy.
- Central banks are maintaining their higher for longer rhetoric. But we see signs that a sustained fall in inflation is underway.
- We are watching US employment data closely – and so is the Federal Reserve. If a US recession does occur, we expect it to be short and shallow.
- The prospect of a downturn would prompt a reversal in Fed policy. And that would be good news for bond markets.
There has been a hefty rise in government bond yields in recent weeks and months. Returns from government bonds have been negative and this has depressed financial asset prices across the board. Here we consider the reasons behind the moves with a view to looking ahead to the prospects for bonds and financial assets more broadly.
The chart shows that the rise in US & UK yields has reversed most the decline over the previous 20 years. From near zero at the height of the height of the pandemic, 10-year yields are now above 4.5% in the UK and US.
Yield on 10 year government bonds
Source: Columbia Threadneedle Investments and Bloomberg as at 9 October 2023
Much of the move reflects central bank policy of course: the Federal Reserve (Fed) and the Bank of England (BoE) have raised official rates from near zero and switched from Quantitative Easing (QE) – whereby they bought up vast quantities of bonds – to Quantitative Tightening (QT), reversing the process. Other central banks have done the same and even the Bank of Japan which kept their bond yields close to zero even before the pandemic, are now allowing yields to rise.
All this is familiar stuff. But the moves in recent weeks have caused economics and central bankers to reconsider their views about interest rates and yields in the longer term.
Standard economic theory suggests that central banks can affect real interest rates but only over the time period that it takes for inflation to adjust to their targets. QE and QT can affect longer term real yields via the term premium but that should be a modest effect. The latest thinking is that official rates, typically with a maturity of days, can affect much longer-term yields for extended periods.
Almost everyone agrees that the central banks were slow to respond to the surge in inflation following the pandemic. But markets compounded the central banks’ error by assuming that a modest rise in official rates would be sufficient to snuff out the inflation pressures. As it has become clear that rates would have to rise further for longer, longer term rates may have overreacted.
If, as I believe, a sustained fall in inflation is underway, most notably in the US but also throughout the rest of the developed world, we can look forward to a significant rally in government bonds as central banks begin to gradually unwind their tightening policy.
This is all very well but markets are moving in the opposite direction. What might turn it all around? In recent weekly updates I’ve been arguing that inflation has improved markedly in the US and that a similar pattern is likely to follow in Europe and the UK. But central banks are afraid to take their feet of the brakes for fear that the recent improvement might be temporary. Detailed work by the IMF, the Bank for International Settlements, not to mention speeches by central bankers themselves have noted that these temporary respites have often been a feature of previous inflationary episodes. That would all change if, as I expect, unemployment starts to rise. Last week’s unexpectedly strong rise in US employment might be taken to suggest that this is a long way off but I disagree. The US labour market is already easing and the recent rise in yields will cause a further drag. Labour supply is on the rise, led by immigration, and US unemployment has already edged higher despite the rise in employment. If US unemployment were to sustain a modest further rise for three months it would then breach the Sahm Rule. This would suggest that the US economy was moving into recession. It is a more accurate indicator that than more familiar yield curve and is closely followed in the Federal Reserve. If a US recession were to materialise, I would expect it to be brief and shallow, but the very prospect would lead to a major change in Fed policy.
US inflation has already fallen significantly and in my scenario, the Fed would see the balance of risks shifting from easing too early to keeping rates too high for too long. That shift should be underway early in 2024. And if I’m right that would be good news for bonds and, despite the hit to earnings, relief for equity markets too.
