Commentary on Political Economy

Friday 14 May 2021


The Real Reason Why U.S. Bond Yields Are Stuck

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.  

Where’s the yield?
Where’s the yield? Photo: Bloomberg

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.

Relative Returns

Hedged pick-up in yield of 10-year U.S. Treasuries compared with 10-year German and Japanese government bonds

Source: Refinitiv

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.

Let’s think about that for a moment. The U.S. economy is likely to register growth in the current quarter of about 15% compared with last year, but yields have pretty much never been lower. Admittedly, there are favorable base effects since the economy last year was so depressed. But stock markets are still not far from record highs and the government has announced that it wants to throw $6 trillion at the economy in coming years. Rather than lean into the wind, the Fed is in effect relaxing monetary policy by allowing real rates to collapse and financial conditions to loosen.

And it is doing so at a time when inflation is rising very rapidly indeed. Demand is up, supply is not and inventories are very low. In the dim and distant past of a few months ago the Fed said it would target inflation over the whole cycle. Now every Fed member says its inaction is justified because inflation will be temporary. These two positions are conflicting. 

If you believed the inflation target was credible, an inflation print of 4.2% (assuming that inflationary pressures continue to mount and PCE inflation is almost as high) would bring the Fed closer to a rate rise. In contrast, the recent claims that higher inflation is temporary are an article of faith. It doesn’t force the Fed to do anything at all if it continues to cling to this view. 

The Fed claims that inflation will eventually come down again because people haven’t adapted their behaviour. Are these, I wonder, the same people surveyed by the University of Michigan who now expect inflation to average a little under 3% over the next five years? And how on earth could it know?

Central banks around the world are conducting untried monetary policy on a huge scale, the Fed not least. In effect, it’s saying that the combination of huge and unprecedented monetary and fiscal policy hasn’t had and won’t have the slightest long-term effect on inflation or behavior. 

The current Fed regime makes the Greenspan one, which allowed the inflation of the late 1990s stock bubble and encouraged the subsequent housing bubble, look like a model of sober reflection. At some stage the Fed will have to recognize reality. And bond prices of all stripes will fall with a resounding thud. In the meantime, inflation and breakevens will keep rising. 

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