As global interest rates began to rebound since reaching all-time lows in July, many investors are asking: is the 35-year bond rally over? In more-recent context, is the central bank experiment that conjured never-before seen negative rates, over?
Most observers attribute the rise in rates to the Fed’s expected interest rate hike in December. This is only part of the reason, in my view. I described earlier market forces that now drive Treasury yields up and bond prices down: inflation and foreign currency exchange (FX). Today, I will recap them briefly, and provide updated data.
Bond prices, which are inverse to yields, began to fall after peaking in mid-July. The 10-year Treasury yield rose from a bottom of 1.37% to 1.85% currently, an 25 basis-point (or ¼%) rise so far in October – a substantial move in the current environment of ultra-low rates. Bonds price moves depend on their duration – the 7-10 year Treasury index (IEF), for example, is down 2.2% since June 30th.
Bond Total Returns Since June 30, 2016
Source: market data
As I wrote previously here and here, inflation pressures are rising this year. In contrast with earlier market consensus regarding continued deflation, the expectation of a gradual rise in inflation is slowly becoming accepted by investors. Core CPI inflation, which excludes food and energy, has remained between 2% and 2.3% for about a year, and currently stands at 2.2% (see chart). Total inflation has begun to rebound – in fact, it jumped from 1.06% in August to 1.46% in September. This, of course, is still fairly low, but even if this low inflation persists for years, Treasury yields up to 5y (now 1.35%) do not compensate for inflation.
In addition, it’s only a matter of time before total inflation rises to core inflation (2.2%). The rationale remains unchanged since my previous posts. Energy is the most important driver: oil price jumped from mid- $40’s to $50 per barrel, while falling year-ago prices will strengthen the “base effect” in the coming months.
Inflation and Oil Price, 3 Years
Pressure on Treasuries from FX
FX markets put increasing pressure on Treasuries this year. Large moves in the Chinese yuan, the Japanese yen, and the British pound after Brexit, required central banks to intervene, which began to put downward pressure on U.S. Treasury prices (upward pressure on yields).
See my previous post for a more complete (and somewhat-long) explanation. Simply put, central banks want their currencies to weaken, but not a free-fall. Note that when a central bank buys or sells “dollars,” it typically buys or sells U.S. Treasuries. To that end, here’s what happened:
- The Chinese yuan has been falling since 2014 (rising blue line means weaker yuan vs. USD). The PBoC has to intervene periodically to buy the yuan and sell dollars (i.e., U.S. Treasuries) in order to prevent the yuan from falling too quickly.
- The British pound plunged after Brexit, and the BoE had to buy sterling and sell dollars to support it.
- After falling in previous four years, the Japanese yen rallied strongly this year to 100 Y/$. The BoJ bought dollars and sold yen, pushing it to 104 Y/$. This earlier buying of dollars offset some of the selling by China and the U.K. After the yen weakened however, the BoJ stepped away from the FX market, no longer providing an offset.
Source: U.S. Department of the Treasury
China’s and Japan’s central banks are massive holders of Treasury securities, with about $1.2 trillion each. You can clearly see the trends of declining Treasury holdings on the above chart (now updated through August-2016).
Yuan As Reserve Currency
The accelerated decline in China’s Treasury holdings in July and August are notable on the above chart. This might be due to the recent shift in global financial infrastructure not seen since the early 1970’s. I’m referring to the formation of the China-led Asian Infrastructure Investment Bank last year, and China’s long-coveted admission of the yuan to the IMF’s list of reserve currencies which just came into effect on September 30, 2016. I don’t mean to sound alarmist, but when the AIIB was formed, Lawrence Summers warned that “the United States lost its role as the underwriter of the global economic system.”
Due to wider acceptance of the yuan on global scale, there will likely be less demand for U.S. dollars and U.S. Treasuries. The PBoC may have begun to diversify its holdings into the yuan from USD (and other currencies) in July in anticipation of the IMF decision being finalized in September. Because China is the largest lender to the U.S., its selling, or even not buying as much of Treasuries, will likely put upward pressure on U.S. Treasury borrowing costs going forward.
Rising inflation, FX market trends, and China’s shift to the yuan combined forces since July to drive longer-term U.S. bond prices down, and yields up. These market trends, added to the expectation of the Fed raising the funds rate this year, will likely continue downward pressure on bond prices.
In my mid-October blog, I wrote that if the 10y Treasury doesn’t hold below 1.80%, then it may jump to 2% quickly. This is largely psychological – if I’m a bond trader and I see yield rising from 1.40% to 1.84%, I’m thinking 2% is near. The 1.80% level was just breached today, so 2% is within striking distance. This is probably the baseline, most likely scenario in the short term.
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