Yields on U.S. government bonds have reached the lowest point since February as investors’ optimism on the pace of economic recovery begins to wane. At the height of the ‘taper tantrum’ in the first quarter of the year, bond prices rose sharply, peaking at 1.73 in March before cooling off. However, bond prices reclined and have been on a downward trajectory since then, falling to as lows as 1.17%.
So, what are the factors that have led to the decline in Treasury yields for the greater part of the last six months? To have a clear picture, we need to have an understanding of how Treasury yields work.
10-year Treasury yield: the economy’s barometer
Investors, economists, and financial experts keep an eye on Treasury yields which are usually used as a barometer to gauge the direction of the economy. Treasury yields are important because they are used to set benchmark interest rates from everything from mortgages to corporate bonds.
The 10-year yield is the most closely watched because it rises when the economic growth outlook is optimistic and declines when the outlook is not bright. This is because during periods of economic growth, investors have the confidence to take on more risks and as such do not seek the safety of bonds. This sends the price of the 10-year treasury bill lower and yields higher.
On the contrary, during a recession or slowing economic growth, investors lose confidence and seek the safety of bonds that are regarded as safe-havens. This sends bond prices higher and yields lower.
Based on the above, we can aptly pinpoint the reasons for the decline in 10-year yields.
Slowing Economic recovery
Investors are beginning to price in signs of slowing economic growth. The June jobs report showed an unexpected increase in unemployment rates in June. Jobless claims rose to 5.9%, even though the labour force participation rate remained at 61.6%.
Labour shortages and rising wages are putting pressure on the labour market as companies are scrambling to hire the best hands. The economy still has a shortfall of 6.8 million jobs from its pre-pandemic, while the jobless rate is still above the 2019 level of 3.5%.
Sectors such as restaurants and leisure which account for most part-time workers and absorb most of the new entrants into the labour market are not yet operating at full capacity, thus leaving a lot of people off the labour grid.
A plethora of reasons has been given for the labour shortages and subtle spike in unemployment rates. One of such is that many workers have refused to go back to their old jobs. The pandemic brought some sense of reckoning to most people as they have realigned their priorities and hope for a fresh start. Another reason is that it pays more to be unemployed and receive government stimulus cheques plus unemployment benefits checks than going to work
Fears that the Delta variant would slow the pace of economic growth is growing. This is coming amidst lockdowns that are resurfacing in various Asian countries. Australia, Japan, and Thailand have been forced to place some regions under lockdown as infection cases rise. In the US, hospitalization numbers are on the increase especially in states that have low vaccination rates. This is coupled with the fact that the vaccine may not provide full immunity against the delta variant.
Already some events are being cancelled, while companies are now mandating vaccinations from workers and visitors to their offices. Though no one is expecting a second total lockdown, it is believed that the Delta variant would roll back the timeline for full economic reopening. This has sent jitters among the investing community as many are seeking the safety of bonds.
Expectations of tightened monetary policy.
There are growing concerns that the Federal Reserve may begin to raise interest rates sooner than expected if the current inflation persists. This standpoint has been echoed by the Fed Reserve Vice Chairman Richard Clarida who said the central bank may raise interest rates as early as 2023. On the other hand, the Dallas Fed Bank President Robert Kaplan said he expects the central bank to raise rates as soon as 2022.
The sharp increase in the CPI and PPI, which rose to their highest level in decades may force the central bank to recant its earlier decision on inflation being transitory. This implies that the Federal Reserve would have to tighten its monetary policy which could, in turn, dampen a consumer-led recovery and drive demands for wage increases. Already the Federal Reserve has brought forward the timeline for an increase in interest rates by a full year.
Bond traders caught in a limbo.
Based on the current macroeconomic conditions, analysts expect the 10-year yield to touch as low as 1%, or below before the year runs out. But this has put bond traders in limbo. Ordinarily, as inflation ticks up, Bond yields are expected to rise as investors would demand more compensation for the erosion of monetary value that accompanies inflation. However, this is not the case as yields are going lower while inflation is heating up. More confusing is that equities and stock indexes have been accelerating and are currently flirting with record highs.
Though the fed chairman Jerome Powell says inflation is transitory, there are sticky parts that have to be considered. For example, the wage increases which have been necessitated due to labour shortages are not going to come down when the economy fully reopens. There is also the possibility that the US economy may be heading towards stagflation characterized by rising prices yet stagnant economic growth.
As such, the forecast of yields going down to 1% or lower may not be far-fetched especially in the coming quarters when the effect of inflation would begin to show on the companies’ balance sheet when they release their quarterly results.Leave a comment