Central bankers sanguine about steeper yield curves
In the past week, there has been much attention on the rise in the US benchmark 10-year bond yield, reaching 1.3% or its highest level for a year. Closer to home, a similar trend was seen; during the month of February, UK 2-year bond yields are up 7 basis points (bp), albeit still slightly negative, while 10-year yields have risen 29bp to 62bp.
Why has this happened?
Commodity prices are one explanation. Although any jump in food or raw materials costs is often transitory, it is noticeable that there is a relationship between changes in commodity prices, especially oil, and the direction of the bond market. This week the cost of Brent oil reached a new high at $65 per barrel. OPEC has been more capable of managing its output, but a driving force was the weather – very cold temperatures across America, especially the blizzards damaging the energy system in Texas, caused demand to spike. Elsewhere, strong industrial demand is feeding into a wider complex of raw materials, such as copper at an 8-year high. All the signs are the consumer and producer price inflation have bottomed out at the end of last year and are set for a noticeable upturn into 2021.
A second factor causing the sell-off has been evidence of current or future economic strength. In the USA retail sales jumped over 5% in January on the back of stimulus cheques, even before Biden’s $1.9 trillion package passes Congress. In the UK, the success of the vaccination programme has sparked the debate about when the lockdown might end, with Andy Haldane attracting attention for his comments about the economy being a coiled spring due to the abundance of savings ready to be spent. Over in Asia, a spate of economic statistics from China, Japan, Korea or Singapore indicated the strength of the manufacturing sector.
Behind the scenes, many economists are worried about the long-term scarring effects of the pandemic on economies, while the implications of the ‘Build Back Better’ programmes on debt issuance are still to be assessed. However, the time horizon for most bond investors is understandably relatively short-term at present.
Central bankers show that they are not concerned about such developments. The latest Federal Reserve minutes indicated that monetary policy is not likely to change soon as the economy still has a long way to go before the Fed reaches its growth, employment or inflation targets. Many participants stressed the importance of distinguishing between one-time changes in relative prices and adverse changes in the underlying trend for inflation. All in all, the Fed remains calm in the face of inflation upside, and there are no tapering signals yet. It is no surprise, therefore, that the markets are not pricing in the initial rate hikes in America before 2023.
As bond yields edge higher, so there is a wave of interest from investors desperate for a yield in this environment. Governments are also taking advantage of historically low rates to embed low debt servicing costs for some years to come. The outcome has been massive demand for long-dated issues. As just one example, Italy received more than €110 billion of demand for its 10-year bond offering, more than 10 times the amount on sale. Elsewhere, Spain sold €5bn of 50-year bonds at a yield of 1.45% and Belgium launched a 50-year issue at 0.69%. It will be interesting to see around the time of the Budget what the Debt Management Office plans are for issuance in 2021-22. After all, the latest estimates from the Institute for Fiscal Studies are that the Chancellor will need to borrow between £125-175 billion in the coming year. The balance of short dated and long dated bond issuance may also have an impact on the shape of the UK yield curve, another factor affecting currently negative yields at the front end.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making