26 February 2021
The increase since the middle of last year represents, firstly, the removal of significant downside risk for the global economy and, secondly, growing optimism about the outlook for growth. The bond markets are neither showing any great concern about inflation risks nor pricing an early lift-off for short rates. Risks are probably still tilted somewhat to the upward side but global yields are now priced closer to plausible equilibrium.
Global government 10-year yields in the major markets (ex-Germany and Japan) have increased by about 60bp since the beginning of the year. This extends the upward move since the middle part of last year when optimism started to revive about the global economic outlook. The average increase in 10-year yields over the entire period is now about 80bp.
The upward move in yields gained new momentum in the first two months of this year. Economic optimism has been given a fresh lift by the rollout of vaccines to tackle the pandemic and extraordinary policy stimulus. Hence the consensus expectation of GDP growth in the US has increased for this year from below 4% to almost 5%, for example.
The more recent move in bond yields has several features:
First, since the beginning of this year, and especially through February, the largest increases have been seen in Australia, Canada and the UK. To some extent, this reflects the usual pattern in a phase of rising global yields. In the case of the UK, the increase probably reflects perceived success in rapid implementation of the vaccination programme.
Second, there has been an upward re-pricing of forward short-term interest rates for longer horizon dates. For example, in the US the forward overnight rate at 5-year and 10-year horizons has increased by about 75bp and 100bp, respectively. The major central banks remain committed to very expansionary monetary policy and maintaining policy rates close to zero in the near-term. Hence, forward overnight rates at 2-year horizon are little changed.
Third, the upward move in nominal 10-year yields has consisted almost entirely of higher real yields, especially in the more recent period since mid-February. Again, this is consistent with more optimism on the outlook for global growth. Previously, the upward move in yields during the second half of last year chiefly reflected higher breakeven inflation rates. The prospect of economic recovery helped to re-anchor inflation expectations closer to target in the US, though not in the Eurozone.
Fourth, yield curves have become steeper. This is consistent with the re-pricing higher of more distant forward short-term interest rates. There is also some evidence of a rebuilding of risk premiums on longer maturity bonds. This is illustrated by the steeper slope of the curve between intermediate and long-term maturity bonds. For example, the slope between 5-year and 30-year yields in the US had increased from 130bp to 165bp before falling back slightly. The increase in bond yields during a sell-off is usually greatest in the intermediate sector of the curve.
The re-pricing of global government bonds has attracted increasing attention from both market commentators and policy makers. The increase in real yields and steeper yield curves should be viewed as a benign reflection of the economic outlook. Thus, at least until the very recent past, equity and credit markets have continued to perform strongly. The ECB has expressed cautionary remarks about the potential threat posed by higher bond yields, however, indicating that there is no early end in sight for large-scale official purchases of longer-maturity bonds.
Turning to the outlook, the recent re-pricing of yields appears more consistent with plausible equilibrium, at least in the US. The term structure of real rates in the US is consistent with a small further move higher to about 50bp in the longer-term. This remains considerably below longer-term history but unwinds the overshooting to the downward side that occurred during the early phase of the pandemic. At the same time, the term structure of breakeven inflation rates is relatively flat at about 2%.
The risk for global yields is probably still tilted a bit to the upward side. That is for several reasons:
First, policy rates in the majority of advanced economies are priced to increase by only 50-100bp on a 3-year horizon, although not in Japan or the Eurozone, where forwards project almost unchanged policy rates. This would still leave overnight rates deeply negative in real terms. Indeed, the overnight rate in the US, for example, is not priced to be positive in real terms until beyond the 5-year horizon.
Second, inflation expectations have room to move higher. That is most obviously the case in the Eurozone and Japan. There is also room for inflation expectations to increase in the US, consistent with the Fed’s new “average inflation target”. This could allow for the anticipation of some overshooting of the 2% target in coming years.
Third, the yield curve slope is only at its long-term average. With the exception of Australia, the slope between 2-year and 10-year yields is sat close to long-term average in other major markets, even after the recent increase in long-term yields.
Fourth, the high degree of fiscal policy stimulus combined with accommodative monetary policy creates the possibility of policy error. High household saving rates represent pent-up demand which is likely to boost spending as economic activity recovers. The tilting of risk to the upward side for both growth and inflation is probably consistent with the rebuilding of higher risk premiums at the longer end of the yield curve.
Countering these upside risk factors somewhat, uncertainty with regard to the virus could lead to higher precautionary saving and reduced investment demand for an extended period. This would leave the major economies in a position of excess capacity for longer. An extended period of bond purchases by the leading central banks would also mitigate further upward pressure on long-term yields.
The key things to watch in the short-term are firstly whether markets get ahead of themselves in pricing early central bank tightening and, secondly, whether higher long-term interest rates undermine asset prices and lead to an undesirable tightening in financial conditions. Some combination of these two factors would likely attract renewed buying interest in global government bond markets.