Why did bond yields spike and is there more to come?

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Bond yields have been on a rollercoaster ride in the past few years. We came into 2023 with the US 10-year government bond yielding 3.8%, following a dramatic repricing in 2022 when yields shifted from a pandemic low of 0.5%.?

The journey for bond investors hasn’t been much easier this year. Yields fell to 3.3% in April but have since backed up, touching 5% in October. The question this month is: what is driving the spike in bond yields, and is there more to come?

Some of the recent bond market volatility has been driven by the horrific events unfolding in the Middle East. Investors are trying to work out whether the prospect of higher oil prices damages economic growth, and therefore reduces the outlook for interest rates, or whether higher inflation puts the central banks in an even tighter spot and feeds the “higher for longer” narrative.

Beyond the recent events, a concern commonly discussed is a demand-supply mismatch in the market for government bonds, particularly in the US Treasury market. With a considerable amount of US government spending already legislated for, the concern is that issuance of government debt is overwhelming bond demand now that the Federal Reserve (the Fed) is no longer buying Treasuries. Other buyers from former zero interest rate regions – such as Japan – also increasingly have options at home.

Ever higher yields are thus required to tempt private investors to the table until sufficiently high interest rates cause a fiscal rethink.?

Chart 1 - A mismatch in supply and demand for US government bonds

At face value, this concern about a demand-supply mismatch has merit. Central banks absorbed a lot of the government debt issued in recent years and now seem firmly committed to reducing their balance sheets by not reinvesting the proceeds as bonds mature.

However, if private investors were worried about the uncontrollable profligacy of government spending, one?might have expected the rise in yields to have been driven at least in part by concerns about inflation. Instead, the recent move has been almost entirely driven by real yields.

Chart 2 - The recent rise has been driven by real yields

The reason for rising bond yields that I find most compelling is that the US economy has proved so resilient to higher interest rates thus far that the market is re-evaluating its perception of what the sustainable, or “neutral”, interest rate is. As Chart 3 highlights, what is happening is investors are pricing out the cuts that they had previously anticipated and expecting interest rates to be held at much higher rates than they previously thought possible.?

Chart 3 - The market is acknowledging a 'higher for longer' rate outlook

The sustainable rate of interest is sometimes referred to by economists as r*, or the interest rate that would prevail when the economy is at full employment and inflation is stable, such that monetary policy is neither expansionary nor contractionary.???

The r* rate changes over time in a way that is notoriously hard to gauge in the moment. It is often thought about in real terms, with the inflation component being assumed to be the inflation target (though as per earlier blogs, whether 2% remains the sacred number is itself up for debate). The real r* should then be dependent on the balance of demand and savings (at home and abroad), which in turn depends on demographics and factors that influence whether savings or investing is more attractive, such as productivity and risk aversion.?

The manner in which all these unobservables move makes life as an economist, and a central banker, incredibly hard. Many central banks refuse to even have a go at putting a number to r*. The Fed is one of the brave ones, but as can be seen in chart 3, there is a clear tendency for its estimate to be revised slowly, and only after having benefited from a considerable degree of hindsight that savings and investment, and therefore growth and inflation, are not behaving in reaction to interest rates in the way that might have been expected.?

The last decade is a case in point. Economists – including those in the Fed (Chart 4) – continually revised down their forecasts of the long-run real r* as ever more expansionary monetary policy did little to lift growth or inflation.?

Chart 4 - Will the Fed lift its projection of the long-term federal funds rate?

So back to our question - will bond yields rise further?

The answer depends on what we learn about r* in the coming months. If the US economy remains strong without reigniting inflation it will be clear that the US has shifted to a new equilibrium and a new r*. The market will continue taking out the interest rate cuts penciled for next year and longer-term bond yields could push higher.?The Fed will also eventually have to revise its estimate of the long-run r* though probably long after the market has already completed its rethink.

If, however, the economy shows signs of cracking under 5% policy rates then perhaps the Fed’s r* isn’t so wrong after all. As discussed in my last newsletter,?I think this scenario is more likely and so I am enticed by locking in income at the yields currently offered by the core government bond markets.?

Explore our Guide to the Markets here.

All data is sourced J.P. Morgan Asset Management as of 31 October 2023.

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