The Kraken stirs
Economic data have been unsurprising this week, politics is steady as she goes, whilst vaccination programmes continue to roll out steadily. In parts of the fixed income world, however, various signs of stress are appearing – the global bond market is experiencing its worst start to a year since 2015. Perhaps the dragon will go back to sleep of its own accord – but central bankers felt it necessary to talk in calming tones.
The uptrend in bond yields has become a very noticeable feature of 2021. Looking at the de facto global benchmark, the US 10-year yield has risen about 0.5% since the start of the year to breach 1.4%. Other markets have followed suit – the 10-year Bund yield has risen from minus 0.6% to minus 0.3%; Australia’s 10-year bond yield has surpassed its pre-pandemic level; Japan’s benchmark poked its head above 0.1% for the first time since 2018. Turning to the UK, then gilts have suffered the sharpest monthly sell-off since 2016, with yields above 0.7%. To put such developments into price terms, then since August the price of the iShares 20+ Year Treasury ETF has fallen from 170 to 140.
The reasons are obvious: confidence has improved among investors about the outlook for the global economy, while headline inflation is rising and commodity prices surging. The probability assigned by the market to the Federal Reserve raising interest rates in late 2021 has risen, even if it remains low. A further factor, however, is the expectation that fiscal policy will remain extremely easy all this year, meaning a very large amount of debt issuance for markets to digest. Janet Yellen, the US Treasury Secretary, has talked about another mega package following the $1.5-1.9 trillion programme going through Congress, whilst in the UK tax increases being mooted by the Chancellor appear limited. In addition, there are technical factors relating to convexity hedging, whereby some analysts warn that the downward momentum in bond markets could become self-fulfilling, due to forced selling by some investors amidst refinancing problems. A further concern is that the amount of liquidity being created by central bankers is enabling bubbles to form, in areas such as cryptocurrencies, which eventually they will need to bring under control.
Moving away from benchmark yields, other problems are being seen in shorter dated bonds. The spread between the two-year Treasury yield and the Federal Reserve’s key interest rate is the narrowest since the market sell-off when the coronavirus first appeared, a potential sign of financial-system stress. A narrower spread is seen as reflecting strong appetite for short-term debt as many corporates and institutions seek a home for their plentiful reserves.
It was rather interesting that despite such historically small moves in bond yields, a number of central bankers decided it was necessary to calm down market nerves. In his prepared testimony to Congress, Jerome Powell was at pains to cool interest rate fears. ECB President Christine Lagarde said that policymakers were “closely monitoring” the situation, whilst Board member Isabel Schnabel went further: “We will ensure that there is no unwarranted tightening of financing conditions. A too abrupt increase in real interest rates on the back of improving global growth prospects could jeopardise the economic recovery”.
However, actions sometimes speak louder than words. The Reserve Bank of Australia restarted its bond purchases this week to quell the rise in government bond yields. It sharply increased the amount of 3-year bonds it was offering to buy in its regular market operations, apparently aiming to restrain the jump in yields above its 0.1% target.
What might happen next? Perhaps market nerves will calm down. If not, then central banks may need to step up their talk and back that up with purchases. For example, with the EU yield curve now in positive territory from 15 years onwards, the bloc’s pandemic bailout is no longer ‘free’. If the reflation trade continues to worry central bankers enough, then some like the ECB may be forced to follow in the footsteps of the Bank of Japan and formally adopt yield curve control.
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