Don’t think it’s because inflation is temporary. It’s more to do with the returns on U.S. debt being far better than what’s on offer in Europe and Japan.
Here’s a conundrum. Why, when growth and inflation are picking up sharply, are U.S. bond yields stuck at modest levels? Yields on 10-year Treasuries are lower now than at the end of March, despite this week’s blowout inflation numbers and accelerating growth. The Federal Reserve wants you to believe this is because the inflationary spurt is temporary. It’s got nothing to do with that.
The reason bond prices are stuck is much more to do with the fact that monetary policy is global and that the hedged returns available on U.S. debt are much higher than the insults that pass for bond yields in Europe and Japan.
This trade works for three reasons. The first is the simplest: Treasury yields are a lot higher than those in Europe and Japan. The second is that the Fed has sat remorselessly on short dollar rates, which makes swapping from, say, euros into dollars much cheaper. The third and slightly more complex reason why international investors are buying Treasuries is that the Fed flooded the world with dollars and thus caused the cross-currency basis swap — essentially, the cost of borrowing dollars abroad — to fall precipitously, having spiked at the start of the pandemic. The chart below shows the 10-year returns in dollars relative to the 10-year returns in Germany and Japan.
Hedged pick-up in yield of 10-year U.S. Treasuries compared with 10-year German and Japanese government bonds
Note: Hedging costs are calculated using annualized three-month forwards.
It’s also instructive to look at the remarkable stickiness of U.S. bond yields by splitting the yield into its real yield and inflation components. This is easy to do using TIPs (inflation-linked bonds). The yield on a conventional bond minus the yield of an equivalent maturity TIP gives you the breakeven rate: essentially, the expected inflation over the life of the bond. And what this shows is that even as overall bond yields have stayed constant of late, expected inflation has continued to rise. Over the past 12 months, five-year breakevens have risen almost two percentage points, to a touch less than 2.7%. Some 15bps of that rise has come since the end of March.
The eagle-eyed among you will also have twigged that if overall yields haven’t moved lately, and expected inflation has risen, then real yields (the yield on the TIPs bond) must have fallen. Have a gold star. U.S. five-year real yields are now minus 1.9%, close to a record low.