Fears of a bond market rout are overdone

US 10-year Treasury yields have risen by around 15 basis points this year, reaching their highest level since March 2017. While a relatively small move, the back-up in yields has prompted some prominent bond investors to pronounce that the 25-year bond bull market is over.

But we believe the reasons behind the sell-off are unlikely to lead to a sustained move higher in yields and see little cause for alarm.

• US 10-year Treasury yields hit a fresh 10-month intra-day peak just shy of 2.6% on 10 January, after a Bloomberg report stating that China was considering slowing, or halting, its purchases of US Treasuries. With the US currently contemplating trade tariffs targeting China, the report – subsequently officially denied – may have been political saber rattling by the Chinese. From an economic perspective, it makes little sense for China to take action that could hurt its existing Treasury portfolio. In order of importance, China’s reserve management goals are safety, liquidity, and yield; Treasuries remain the best vehicle to achieve all three objectives. China is the world’s largest holder of Treasuries, with nearly USD 1.2trn in holdings; selling down its portfolio would incur significant losses.
• With the recently passed tax reform bill likely to put upward pressure on the size of the US budget deficit, and with the Federal Reserve now shrinking its balance sheet, concerns have arisen that supply will weigh on the Treasury market. But there is little evidence of lack of appetite for Treasuries. Last week’s 10-year Treasury auction on 10 January showed strong buying interest, with the highest bid-to-cover ratio since June 2016. The pace of the Fed’s balance sheet reduction is very gradual, with the end point expected to be significantly higher than pre-crisis levels at around USD 3trn. Also, as the Fed reduces the overall size of its balance sheet, it will increase the amount of longer-term debt it purchases as it replaces maturing short-term bonds in its portfolio.

We don’t expect the spike in yields to go much further.

• We would be more concerned if the back-up in yields reflected rising real rates, but an important factor behind the increase is rising inflation expectations. US 10-year breakeven inflation rates have increased by 30bps over the past six months, driven by higher oil prices, dollar weakness and tax reform. Real rates in contrast have declined by 10bps over the same period. Protests in Iran and freezing temperatures in the US have recently pushed oil prices higher. US shale production is increasing as a result and we expect crude prices to fall back in the coming months which should moderate inflation expectations.

So we don’t expect the spike in yields to go much further. While we are monitoring US Fed policy, the central bank doesn't appear to have made any major changes in its approach, with two or three rate hikes likely this year and Fed expectations for a terminal rate of around 2.75–3%. Provided this remains the case, the upside for US 10-year yields looks relatively limited.

Bottom line

A relatively modest uptick in US 10-year yields at the start of the year has been sufficient to prompt talk of the end of the 25-year bull market in bonds. But we believe the reasons behind the rise – possible shifts in Chinese demand for US Treasuries, a potential supply overhang and rising US inflation expectations – are unlikely to drive yields significantly or sustainably higher.

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