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In a key global development, US long-term government bond yields have spiked higher in recent weeks. The yield on the 10-year Treasury note has gained around 40bp since late August, in the process decisively breaching the pyschological 3% level. In fact, at the time of writing 10-year yields were hovering around 3.21%.

What underpins these moves? The simplest way to de-construct a long-term bond yield is to split it into the expected inflation rate that is expected to prevail over the lifetime of the bond and the remaining ‘real’ yield that is real, inflation-adjusted return that bond holders demand. Longer-term real yields are crticially linked to the economy’s real or supply-side performance. Although the two do not move in lockstep, the long-term real yield should be closely correlated with estimates and perceptions of the economy’s sustainable long-run GDP growth rate.

As the US Treasury issues so-called index-linked or inflation protected bonds, the bond market’s 10-year inflation expectation or ‘breakeven’ rate can be directly observed. Importantly, inflation expectations have barely budged since late August, only moving up by around 4bp. At around 2.15%, they remain broadly consistent with the Federal Reserve’s 2% long-run inflation target.

There has therefore clearly been no inflation ‘shock’ or ‘scare’ driving bond yields higher. This fits with recent inflation data which have seen the Fed’s preferred gauges of ‘core’ or underlying consumer inflation hold relatively steady around 2%. Importantly, the recently released minutes from the Federal Reserve’s latest policy review showed the central bank’s rate-setters committed to continuing to push short-term rates steadily higher in order to keep inflation well anchored around 2%.

Higher bond yields have, by construction, therefore been almost exclusively a ‘real’ phenomenon. Three inter-related factors can be seen as driving the sharp 35bp+ recent gain in real yields. The first factor is the continued exceptional growth performance of the US economy. After booming annualised GDP growth of 4.2% in the second quarter, everything points to similarly rapid growth in the third quarter. Given current momentum, US GDP growth for 2018 as a whole could easily top 3%.

Second, the Trump administration’s tax cuts and loose fiscal stance are both re-inforcing the economy’s current robust momentum and also working to pressure real bond yields higher. Various studies have consistently found that a one percentage point increase in government debt to GDP ratio adds around 3bp to long-term bond yields. With the Trump tax cuts estimated to add around $1.5 trillion to federal debt over the long-run (around 7.5% of current GDP), the Trump tax cuts could ultimately pressure long-run Treasury real yields higher by more than 20bp.

 

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Third, this cocktail of a booming economy, subdued inflation and huge tax cuts is lifting the animal spirits of US consumers and businesses. Gauges of consumer confidence for example are close to levels only ever previously reached at the peak of the 1990s technology boom. Small business confidence is even more buoyant, reaching 45-year highs in recent months. After years in doldrums, private sector confidence is finally back in the US with avengenace it seems. In turn, buoyant animal spirits are boosting hiring and spending plans and so working to yet further entrench the boom.

Even after their recent move up, implied 10-year Treasury real yields are still shy of 1.25%; below even the most pessimistic estimates of the US economy’s potential growth rate. This is usually pegged somewhere between 1.5%-2% but, of course, may be considerably higher in the short term. Combined with rising federal debt, there is clearly the potential for real and, in turn, nominal Treasury yields to continue to move up.

One crticial stylised fact about US interest rates is that the yield curve – the slope between short-term and longer-term rates – always turns negative at the peak of the business cycle. This maxim has has helkd for over fourty years. The expected peak in the Federal Reserve’s policy rate should therefore operate as an effective cap on longer-term yields.

As already highlighted, the latest Federal Reserve minutes show the central bank’s rate-setters unsurprisingly determined to press with a steady stream of 25bp rate hikes. The Fed currently assumes that it deliver a further five 25bp rate hikes by early 2020 which would lift the policy from its current 2.0-2.25% rate to 3.25-3.5%. Barring an aggressive acceleration in inflation, it is difficult at this stage to envisage the Fed lifting its policy rate either much further or faster than this. 3.5% therefore can be thought as a realistic cap on 10-year Treasury yields unless the inflation outlook dramatically changes for the worst or fiscal policy is loosened further.

Should we be worried about higher US bond yields? Fundamentally, high real yields are good news, reflecting the US economy’s strong growth performance and its continued recovery from the long shadow cast by the global financial crisis. On the other hand, higher yields are a headwind for asset valuations, particularly equity markets, as discount rates are rise. Higher US real rates will also support continued US dollar strength. This in turn will keep the pressure on those emerging markets that have borrowed heavily in US dollars and who are reliant on capital inflows to cover their balance of payments.


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