What Are The True Fundamentals Behind The Treasury Bond ‘Rout’?
The biggest macro-finance story so far this year is the “surge” in Treasury bond yields.
(It is described as a “rout” when speaking about Treasury bond prices… A rise in yield means a fall in price, a loss for bond-holders.)
Since January 1, the yield on the 10-year bond has almost doubled.
The 1st quarter was the worst in decades for holders of long-dated Treasurys. Prices were down about 13%.
“Safe haven” assets like long-dated Treasury bonds are not supposed to lose such a large chunk of the principal so quickly.
However, the significance of this “surge/rout” goes beyond the question of losses to investors holding this particular asset class. The Wall Street Journal has called the 10-year Treasury yield the “most important price in the global economy.” It is the benchmark for the cost of quality-credit everywhere.
- “Long-dated German yields rise to highest in a year, tracking U.S. Treasuries” – Reuters Headline
- “The global government bond sell-off deepened with the 10-year US Treasury yield jumping above 1.4 per cent … European government bonds were caught-up in the selling, sending yields on British, French, German and Italian bonds rising.” – The Financial Times
- “Germany’s 10-year Bund yield has risen from minus 0.62 per cent in mid-December to 0.29 per cent … Australia’s 10-year bond yield has already surpassed its pre-pandemic level to hit 1.61 per cent, while Japan’s this week poked above 0.1 per cent for the first time since 2018.”
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Even in China, our bonds played havoc…
- “In March, with mainland equities continued to tumble, wiping out all gains made since late last year…. A prominent Chinese economist argued that the underlying trigger was a jump in American bond yields that had sparked risk aversion globally and hit China hard. Foreign investors, who had helped fuel China’s equity rally last year, retreated. Reacting to the same signals, big domestic fund managers also rushed to pare their holdings.”
What Is Going On?
The popular explanations are “fundamental.” That is, they assume that Price reflects Value. Bond prices must have fallen because the values of bonds have declined. Fundamentalists see the market as broadly “rational” and reasonably “efficient.”
So, the question becomes: What caused Treasury bonds to lose value?
For some, the decline in the value of Treasury bonds is absolute: bonds are simply worth a lot less than they were in December.
Because… Inflation is about to explode! Yes, after all these years… And we all know (or think we know – it’s in the textbooks) that inflation hits bonds especially hard. It erodes the value of the interest payments, as well as the value of the principal that is returned to us when the bonds mature. The impact is worst for long-term bonds that ripen only in a more distant and uncertain future, which gives inflation more time to devalue the “coupon.” The sell-off has affected the 10-year bonds much more than the 2-year bonds.
Why is Inflation suddenly at hand? – after decades of quiescence, as well as the pretty much complete absence of any immediate evidence of sustained inflation in the data? (As described in my previous column.)
Because… loose monetary policy (for the last 12 years) and now an enormous fiscal stimulus (in the last 12 months) are threatening to drown us in debt, deficits and devaluation of the currency, so we are told, and this will awaken the dragon that has been asleep for decades.
Experts say so.
- “Larry Summers [Harvard economics professor, former Treasury secretary, advisor to Presidents and general know-it-all] warns of the highest inflation in more than half a century.”
It worries some.
- “The higher yields are starting to spook other markets. Stocks are squishy, and corporate bonds are squishy . . . It’s causing people to freak out a little.” – a prominent fixed-income fund manager
It terrifies others.
- “…a rise in inflation-adjusted yields will suffocate the real economy.” – a prominent Swiss banker
The fear is heightened because bond prices have been driven so high, and yields so low, as a result of massive bond-buying programs orchestrated by central banks (like the Federal reserve and the European Central Bank). With yields “artificially” suppressed, there may be nowhere to go but up (for yields) and way down (for prices) when the coiled spring uncoils. If inflation does return, even the safest bonds would be devastated – and smart investors, anticipating this, are getting out now. That is the theory. “Investors are taking cover.”
Or Recovery Euphoria?
Other observers – while still “fundamentalist” – disagree completely as to the fundamentals.
They think the decline in bond prices (rise in yields) is the result of a drop in bonds’ relative value – the value of bonds compared to equities. It is driven by (1) a reduction in the perceived need for “safety” (which bonds offer), and (2) a greater interest in higher returns (which bonds do not offer).
Investing in “safe haven assets” (like Treasury bonds) always involves a calculated trade-off, accepting lower returns as the price of capital preservation during periods of economic or financial market stress. In times of trouble, if enough people seek shelter, they drive the price of haven assets up and the yields down. If the Central Banks join in, buying Treasury bonds to effect a monetary stimulus in response to hard times, the yields go even lower. Those trillions of dollars of central bank buying – which have the inflation party so panicked – have indeed pushed yields down to extraordinarily low levels. Nominal bond yields in many parts of the world are now negative. Indeed, even in the United States real bond yields — the “inflation adjusted yields” that worry the Swiss gentleman cited above – are actually negative.
When investors regain their composure, they may look around and remember that below-zero returns are not what they are being paid to achieve. The S&P 500 index was up 7% in the first quarter — a good 500+ basis points of real, positive inflation-adjusted return. And if it’s fixed-income-type yield you want – regular cash payments rather than more speculative capital gains – the equities world offers dividends. Exxon is paying 6%. Prudential PBIP is paying 5%. Pfizer PFE and Verizon VZ , more than 4%. Once investors decide that they no longer need to accept dismal returns on Treasurys as the price to pay for “safety,” they will begin to sell those bonds and move their money to the stock market.
- “When interest rates are so low, other assets look relatively attractive. Compared with the real yield on five-year Treasuries, shares are cheaper than before the crash of 2000.”
Other haven assets are running the same way. Investment-grade corporate bonds, issued in torrents last year by blue-chip firms, at super-low rates, have also seen reduced investor interest and falling prices.
- “The bond-market rout is dealing a particular blow to investors’ bets on the safest U.S. companies, dragging returns on investment-grade corporate debt to their second-worst start on record. Bonds from highly rated companies have lost 5.3% this year [as of March 19].”
- “Flows into the asset class [corporate fixed income] hit their lowest level last week in about five months.”
Gold – another classical safe haven – had its worst quarter in 5 years. Gold prices have fallen by 12% in the last three months “despite all the inflation talk.” (Bloomberg BusinessWeek)
- [The folks at BusinessWeek seem conflicted as to whether gold is an inflation hedge or not. One recent article lamented that “Gold’s ability to hedge against inflation has been somewhat exaggerated.” But the correlation of the price of gold with inflation since 1968 is negative 45% — so it may never have been a true inflation hedge.]
The flight from safe haven assets that yield very little (Treasurys) or nothing at all (gold) supports the idea that the “rout” is not a rout, but a celebration. It is about yield-seeking – i.e, a renewed preference for equities – rather than fear of damage to bond values caused by inflation per se.
- “The yield on the 10-year Treasury nearly doubled during the quarter as the broader economy showed signs of recovery — a huge boost for financial stocks, which gained 17%. ‘The near doubling of the 10-year yield was overall good for the stock market,’ [said a prominent asset manager]. ‘It’s an unusual combo, but investors saw [the jump in yields] as moving away from deflation, instead of moving toward inflation.’”
Choosing the “Fundamental” Story
The trend over the past year supports the optimistic view. The return of animal spirits in anticipation of a strong recovery is the better fundamental explanation.
In fact, the most recent yield data shows that in the past month the situation has stabilized.
It looks more like a reset to the pre-pandemic norm than a meltdown or capitulation.
One more indication – hi-yield corporate bond yields have not risen. In fact, the yields of the riskiest bonds the have decreased. Which means their value has increased.
Now if the inflation-panic explanation were correct, the yields on corporate bonds should have also surged. Inflation would hurt their coupons just as severely. Yields for all three indexes have traditionally shown nearly identical positive correlations with the the Consumer Price Index (excl Food and Energy) since 1997. (German bond yields and inflation show a similar correlation.)
In other words, bond yields do typically tend to rise — bond prices tend to fall, and bonds lose value – when inflation is heating up. In other words, true inflation impairs the value of fixed income instruments, equally across all categories.
But that is not what is happening now. They are diverging, which is significant. Only Treasury prices are falling (yields are rising). If inflation-panic were the driver, hi-yield bonds should also be suffering. They are not. This supports the view that this Treasurys “rout” is motivated by strong positive sentiment about the economic recovery and a desire to reposition portfolios into the equities market and other risk-assets (such as hi-yield bonds), rather than a fear-driven flight from Treasury bonds based on negative sentiment about inflation.
Sometimes, It Really Is Good News…
Until recently, the inflation-panic narrative was preferred by the majority of the financial press. But despite the intense negative skew in the media (as demonstrated by research cited in my previous article), the general economic outlook is quite positive. As the pandemic comes under control and the economy recovers, a rise in Treasury yields is a typical and a natural consequence, as investors redeploy their portfolios into higher-yielding asset classes. It signals a return to a prosperous “normalcy.”
- “The sharp rise in long-term rates has been a major market feature of 2021, reflecting brighter prospects for the U.S. economy. Even the Fed sees 2021 gross-domestic-product growth of 6.5%, and private economists’ forecasts are for 7% or more, which would be the highest rate of growth since 1984’… Such boom-like numbers don’t jibe with negative real rates; the 10-year Treasury inflation-protected security is trading at minus 0.65%.”
The economic pendulum is swinging back after the shock of the pandemic. Of course, the market may not track the economic news perfectly. Much of the “good news” may be priced in already. Still, this is a moment when the low-yield desert of fixed income looks particularly uninviting. Investors are shifting from defense to offense — which means pulling money out of Treasurys and other haven assets.
There are other explanatory factors besides the “fundamental” ones. Bond prices are also driven by certain “mechanical” or technical forces. This is especially true of Treasurys, and most especially true of 10-year Treasurys – because of the many roles they play in the global financial system, not all of which have to do with considerations of their true value, absolute or relative. In the next installment, I will consider some of these more esoteric aspects of the story behind the movements in the Treasury prices.