Higher US yields are driven by inflation persistence rather than a looming bond market crisis

The recent significant increase in longer-dated US government bond yields has raised questions around whether the US could be at risk of government bond crisis. We think that is unlikely. The increase in yields have been driven by a perfect storm of different factors and associated worries coming together. First, in early August, the US Treasury announced higher-than-expected debt supply, while ratings agency Fitch downgraded the credit quality of the US.[1] Second, the Bank of Japan relaxed its yield curve control policy in July, likely leading to less demand from Japanese investors. Third, Federal Reserve Chair Powell signaled that quantitative tightening may continue into 2024, meaning less central bank buying of US bonds. These factors imply elevated levels of US debt supply, and fuel questions about how easily the private sector will be able to absorb it all and whether the US faces credit-worthiness issues. We are more "sanguine": the most important factor supporting longer-dated yields, in our view, is continued economic resilience and the to-date slow progress on disinflation, suggesting interest rates will remain elevated.

Our analysis[1] shows that deficits, the amount of government bond supply and country-specific monetary policy choices have not mattered much for US 10-year yields, at least for now. What appears to have driven 10-year yields most is the market pricing in a higher "neutral" nominal policy rate across advanced economies. The nominal neutral rate is the estimated rate at which monetary policy is neither restrictive not accommodative over the longer-term. We proxy the market-implied nominal neutral rate through forwards, using the 1-year yield in 10 years' time, which currently stands at around 3.7%, significantly higher than Fed, academic and our current estimate of around 2.5%. If anything, higher 10-year yields have been driven by inflation persistence. Elevated debt supplies and credit worthiness issues have unlikely exerted much influence on yield differences across advanced economies where there are no restrictions on own currency issues.

A simple point to highlight cross-country differences and yield impacts is from the US and Australia. The US has increased deficits and debt supply & was downgraded; Australia reduced its deficit & will have surplus this year. Yet, their 10y yields have moved in sync.

Besides a repricing of the nominal neutral rate, history shows that increasing 10-year yields are nothing unusual at the end of the hiking cycle

Furthermore, a "bear steepening" of the yield curve whereby longer-term yields increase more than shorter-term yields are hardly ever sustained. Indeed, all such moves in the US since 1985 came when the Fed funds rate was at or close to 0% and inflation-adjusted yields were very low or deeply negative. None of this resembles the current yield curve environment.

Can 10-year yields still go higher from here? Yes, but what would most likely be needed is a reacceleration of the economy, including sustained upticks in core inflation and wage growth, and hence a prolongation of the high interest rates beyond what is already priced. While possible, we believe the ultimate upside for US yields is capped: much of current-cycle monetary tightening has already occurred, and we see US grow slowing in the second half of 2023.

We are sympathetic to the view that 10y yields need to go higher to tighten fin conditions. But that's a very different argument vs higher yields due to supply or credit risk.

For insurers, Asset Liability Management (ALM) frameworks partly insulate from strong yield moves. That said, US insurers hold more than 40% of their assets in Treasuries and hence yields very relevant topic.[1] In addition, beyond ALM, violent yield movements can easily have spillover effect on other asset classes, calling for sustained discipline in balance sheet management

[1] Global Insurance Market Trends 2022, OECD 2023

[1] Our analysis uses Principle Component Analysis for five developed-market 10-year yields and the "neutral rate" proxies (US, UK, Germany, Canada, Australia). The first principle component captures 96% of cross-country variation, suggesting that one common factor explains most of the 10-year yield fluctuations. Such a common factor could be a global "neutral rate proxy", which is highly correlated with the 10y yield first principle component and economically makes sense.

[1] Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from 'AAA'; Outlook Stable, Fitch Rating, 1 August 2023.