Will Rising Bond Yields Threaten the Recovery?
GaveKal
Charles and Louis Vincent Gave
December 17, 2010
Last week saw a pretty substantial rise in OECD government bond yields (see The Meaning of the Rise in Bond Yields). Looking ahead, investors are now asking themselves if a new trend is forming and if the multi-year bull market on bonds is over? To answer this, we need to consider a couple of factors:
• Bond yields are not rising because of rising inflationary pressures. After Obama cut a deal on extending Bush’s tax cuts, some market observers opined that bonds are selling off due to US deficit and inflation fears. If so, then we will soon be stuck with a mixture of higher borrowing costs and poor sentiment. This is not good for growth, and would certainly undermine the bull market in equities. However, inflation expectations have moved up only moderately since the tax deal was announced early last week (from 2.38% to 2.43%, based on 20 year TIPS). Meanwhile, nominal 20 year UST yields have jumped much more, from 3.94% to 4.15%. In short, we do not buy the idea that bonds are selling off because of rising inflation or because an expected new supply of government paper (see p. 2).
• Instead, bond yields are reacting to a stronger growth outlook. Leading up to mid-August, bond markets were pricing in a scenario of structurally sub-par growth and persistent resource slack (see Markets are Pricing in a ‘New Normal’). Then, a worried Bernanke fought back by talking up QE2 at the August 27 Jackson Hole meeting. This successfully halted the fall in inflation expectations, returning them to more normal levels. But real yields remained low, on still-weak growth expectations and increased bets for more Fed buying. This combination resulted in the Treasury issuing 5 year TIPS with negative yields! But last month, the growth outlook began to perk up significantly. Data started to pull itself out of the ‘soft patch’ of mid-2010 and US consumers beat the most optimistic of forecasts for Thanksgiving weekend, highlighting a strong holiday season for retail. And now even Washington appears to be making compromises, extending tax cuts and thus further boosting growth outlooks. As such, yields have started to aggressively ‘normalize’. In fact, if we look at 30 year yields (which are less manipulated by QE2 than 5-10 year yields), and deflate them by the structural core CPI rate, it appears that the bond market is back to pricing in the ‘old normal’ (see p. 2). Were rates rising on sovereign risks (like in the PIGS), or on late-cycle monetary tightening, then this would be a concern for growth, equities, and housing. But as far as we can tell, this has thus far simply been a ‘normalization’ of yields on the back of normalizing growth outlooks. After all, the US deficit problem is not new: what is new is that growth began surprising on the upside last month.
If we accept that the movement on bond yields is a normalization on the back of improving growth prospects, then what should bonds do over the near future? Looking through our quiver of historical spreads, real rates, etc… it would be well within the realm of the normal for 30-year yields to rise another +50-80bp, and 10 year yields another +80-100bp (see p. 2). Anything beyond that seems unlikely at this stage. After all, for all the green shoots, the Fed is still buying, consumers are still deleveraging, bank lending is still weak, unemployment remains high, and housing is still depressed… As such, we would not expect much more than the ‘normalization’ we have already seen.
Needless to say, amid super-easy money conditions, the joy over economic momentum might quickly morph into fear of a surge in velocity and inflation. But as we described, this does not seem to be the message from the bond markets today. Instead, the bond markets have simply upgraded their growth outlooks from the ‘new normal’ scenario to a more ‘normal’ growth outlook. As such, we shift from being very bearish USTs to neutral, while we remain overweight US risk assets.
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