3 Is an imaginary number

The US 10-year government bond yield crossed the 3% level this week, reaching a 4-year high. The yield on the 10-year acts as a reference point, and an anchor, for debt prices globally. In general terms, bond yields give an insight into investors’ expectations for interest rates and inflation.

In the US debt markets, 2-year and 10-year benchmark bond yields are both rising. Thus, investors are signalling that higher interest rates lie ahead in the short-term and inflation may tick higher in the long-term.

Alongside changes to interest rates and inflation expectations underway, there are other factors influencing yield levels and we briefly discuss some of the most dominant of these drivers:

• Unconventional Monetary Policy – Over the past decade the US central bank has used quantitative easing (QE) and low interest rates to help stimulate economic growth.

• Asset Purchasing – Through QE the Federal Reserve Bank (Fed) purchased assets, such as bonds. Since late 2008 the level of assets held by the Fed has increased from $1trn to $4.4trn, putting downward pressure on yields and pushing prices of all assets up.

• Interest Rates – Prior to QE in 2008, the Fed cut interest rates to 0.25% (upper limit) pulling down the cost of borrowing to encourage lending between businesses. Today interest rates are trending higher, having been raised six times since December 2015 as the economic outlook improves.

US 10-Year Bond Yields and Federal Reserve Balance Sheet

Source: Office for National Statistics, March 2018.

• Business cycle – With US consumer confidence remaining strong, unemployment still falling and new tax reforms being added into the mix, these factors add further energy to an economy already firing on all cylinders. Seeing this happening bond investors demand a higher return premium (higher yield) to compensate for the threat of higher inflation, which obviously erodes the value of a bond’s fixed rate of return over time.

• Commodity Prices – Another key driver in the short-term is the oil price. Brent Crude has recently spiked to nearly $75 a barrel. As a major raw material used across the economy, higher prices for oil affects input costs of businesses and they respond by pushing up final prices to preserve their margins. Higher costs for goods and services underpin higher inflation expectations and represent another point of focus for bond investors.

Taking all factors together, the 10-year bond hitting 3% is not statistically significant because it isn’t even representative of the long-run post-war average for bond yields which exceeds 5%. Reaching 3% appears to have resonance psychologically, hence the heat generated in the financial press.

Commentators looking for imaginary lines in the sand have something to write about when those lines are crossed. It is true that bond yields have risen from very low levels and it is also true that yields in the 3% range are not inconsistent with an economy in the post recovery phase. The battle against deflation, fought by central banks everywhere after the credit crisis, has subsided in the US. Bond investors are clearly contemplating the next phase, based on improving global economic growth and shifting political considerations around global trade.