As the stock market takes a break for Labor Day, it presents an opportunity to delve into the world of U.S. government bonds. These bonds are influenced by two key factors that impact their yields, which move in the opposite direction to prices.
The Drivers of Bond Yields
The first driver is the short-term interest rates established by the Federal Reserve. Meanwhile, the second factor is the outlook for inflation, given that the returns of interest-bearing securities are eroded by consumer-price increases. Notably, these two drivers are interconnected, as the Fed plays a pivotal role in controlling inflation.
The Impact of Increasing Interest Rates
Bond yields have experienced a significant upsurge since the Federal Reserve began raising interest rates from near-zero levels to over 5% today. In theory, as the government borrows funds for lengthier periods, higher returns are expected. Consequently, when short-term rates rise, long-term rates should follow suit and remain higher than those of shorter-term notes. However, this anticipated relationship hasn’t materialized entirely, but we’ll explore that further later on.
Preceding Factors: Rising Yields
Interestingly, bond yields had already been climbing even before the Federal Reserve initiated rate hikes in March 2022. In 2021, the implementation of substantial government stimulus measures created confidence that the economy would rebound after the pandemic-induced downturn.
A Historic Development
For the first time in 250 years of U.S. history, the 10-year Treasury bond is poised to register three consecutive years of losses in 2023. Analysts at Bank of America highlighted this unprecedented trend on September 1.
The Unexpected: An Inverted Yield Curve
One noteworthy phenomenon that has emerged in recent years is the presence of an inverted yield curve. This occurs when the return on a 10-year bond is lower than the interest rate on a two-year bond. It reflects investors’ beliefs that the Federal Reserve will implement short-term rate hikes to regain control over inflation before eventually reducing rates once again.
Interpreting the Inverted Curve
Traditionally, an inverted yield curve is viewed as an indication of an impending recession, as the Federal Reserve typically lowers rates to bolster economic growth. However, it is important to note that an inverted curve does not necessarily translate to an imminent economic collapse.
Expectations for Longer Term Interest Rates
Despite the recent decline in inflation without a significant economic slowdown, there is a growing anticipation of higher longer-term interest rates. This suggests that the Federal Reserve will maintain elevated rates for an extended period. Furthermore, the decision by the government to increase the size of its debt auctions has also contributed to the recent surge in yields.
On Friday, the yield on the 10-year Treasury reached 4.186%. Although it initially fell earlier in the day due to rising unemployment, it rebounded after a report indicated economic strength. In April, when the economic outlook appeared less stable, the yield hit a low of 3.3%.
Whether yields continue to rise or if 10-year bonds can reverse their three-year decline remains uncertain and hinges on the actions of the Federal Reserve. Nevertheless, Tan Kai Xian, an analyst at Gavekal Research, believes there are compelling reasons to anticipate better returns from bonds compared to stocks in the near future.
The possibility of a weakening economy signaled by rising unemployment may lead investors to sell off stocks as company earnings deteriorate. Concurrently, if rising unemployment provides room for rate cuts by the Federal Reserve, it would boost bonds as well. However, if the labor market continues to expand without a recession, Treasury bonds may underperform.
Nevertheless, Xian noted, “history does not favor such a soft landing scenario.”
In conclusion, the prolonged spell of rising bond yields is highly unusual. Recent events have further propelled yields higher. However, if the Federal Reserve is indeed nearing the end of its campaign of rate hikes, bonds should soon reverse their current losing streak.