Yield Outlook: Too much too soon?
|Have yield dynamics turned a corner? The significant decline in yields over the past month, which contrasts sharply with the dramatic increases earlier in the autumn, could suggest this is the case. Long yields are now back at mid-September levels, with 10Y US yields down no less than 0.6 percentage points over the past month to 4.4%. Germany has seen a fall of around 0.4 percentage points, but the rise in German yields back in September was also less pronounced. US factors have been the principal drivers of the decrease in yields in the past month. Both inflation and non-farm payroll numbers for October were softer than expected, while the Federal Reserve policy meeting in early November underlined that the US central bank is now less keen to raise interest rates. However, what could probably be the most important driving forces of yield movements in the past month have played out beyond the macroeconomic and monetary policy spheres.
Pronounced fluctuations in bond market term premium have driven yields
A key factor behind September’s dramatic increase in yields was rooted in the outlook for the US government deficit and the consequences for bond issuance. Due to the debt ceiling debacle, the US Treasury could not issue new bonds in early 2023 but issuance has since picked up considerably – and we expect next year, in particular, to see a significant upswing in the volume of long bonds coming to the market. The challenge with this is that investor appetite for long bond duration has so far proved lacklustre among ‘traditional’ buyers of US Treasuries (including foreign investors and the L&P industry). In part this is because the correlation between the return on equities and that on bonds has remained positive, making bonds less useful for hedging risk. Meanwhile, alongside the absence of traditional buyers, the Federal Reserve continues to reduce its bond holdings at pace.
This cocktail of rising long bond issuance and declining demand pushed the bond market term premium substantially higher in September/October. However, this has corrected somewhat of late. Earlier this month, the US Treasury’s issuance plan partially dampened fears of a ‘duration bomb’ in 2024, given that much of the issuance is still expected to be placed at the short end of the yield curve. Nevertheless, the term premium on long bonds will most likely remain higher than previously, as the US budget outlook – regardless of the short-term composition of issuance – remains a distinct structural challenge.
There is nothing to indicate that Biden and the Democrats will address the grim outlook for the US budget deficit ahead of the elections next year. More generally, we could ask whether the fragmented political landscape in the US is even capable of delivering the necessary trimming at some point. We have our doubts, and Moody’s decision to put the US’s (last) AAA rating on negative outlook in November due to the budget dispute underscores Washington’s current political dysfunctionality, in our view. In Europe, the supply of new bonds also looks set to be relatively significant next year – just as in 2023.
Moreover, we expect the ECB to opt in favour of accelerating the shrinking of its bond portfolio by phasing out reinvestments of bonds bought under the Pandemic Emergency Purchase Programme (PEPP) earlier that it is currently signalling (reinvestments continuing until the end of 2024). This could justify a higher term premium on European bonds than we have grown accustomed to in recent years
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