Bond prices began to fall after peaking in mid-July. Yields, which are inverse to prices, have rebounded: for example, the 10-year Treasury yield rose from a bottom of 1.37% to 1.78% currently, an 18 basis-point rise so far in October – a substantial move in the current environment of ultra-low rates. While the Barclays U.S. aggregate bond index and 7-10 year Treasury index are both up by about 4.5% in the past 12 months (see chart), they are down between 0.35% and 1.8% since June 30th.
Bond Total Returns, 12 Months
Source: market data
Most observers attribute the rise in rates to the Fed’s expected interest rate hike this year. This is only part of the reason, in my view – the Fed directly sets only the short-term rate (known as the fed funds target rate). Unlike the ECB and the BoJ, the Fed is no longer buying bonds (other than reinvesting interest), so longer-term Treasury yields are, to some extent, set by the market. I describe below two market forces that are contributing to this trend: inflation and the currency market.
As I wrote previously here and here, inflation pressures are rising this year. In fact, core CPI inflation, excluding food and energy, currently stands at 2.3%. In contrast with earlier market consensus regarding continued deflation, the expectation of a gradual rise in inflation is slowly becoming accepted by investors. The rationale remains unchanged since my previous post, with one important new development: oil price jumped from mid- $40’s to $51 per barrel (see chart) on the heels of the agreement by OPEC and Russia to cooperate in capping or lowering production. It’s also important that year-ago prices were falling, so the “base effect” will strengthen in the coming months and likely push total inflation (currently 1.06%) up toward core inflation (2.3%).
Inflation and Oil Price, 1 Year
How FX Affects Treasuries
Interest rates, in theory, drive capital to higher-yielding currencies. In turn, FX markets also affect bond markets in this interconnected world. This increasingly happened in 2016: large moves in the Chinese yuan, the Japanese yen, and the British pound after Brexit, required central banks to intervene, which is beginning to have an effect on U.S. Treasury yields. Here’s how.
Japan and China are very large exporters, so their economies benefit tremendously from depreciating their currencies. Prime minister Shinzo Abe’s bid to revive Japan’s economy hinged primarily on depreciating the yen in 2012 and 2014, as can be clearly seen on the chart above in (the yellow line rising means falling yen). However, it backfired in 2016: market forces sent the yen rallying to around 100 Y/$. The BoJ had to intervene by selling the yen against dollars. Note that when a central bank buys or sells “dollars,” it typically buys or sells USD-denominated securities – mostly U.S. Treasuries.
The situation is largely the opposite with China: the yuan has been “naturally” (without central bank intervention) falling since 2014. If China had let the yuan fall too quickly, it would risk being labeled a currency manipulator (China is already on the Treasury’s “unfair FX practices” list). The People’s Bank of China, then, had to buy the yuan and sell dollars (i.e., Treasuries) in order to prevent the yuan from falling too quickly. In the past two years, the yuan has fallen just under 5% per annum.
Source: U.S. Department of the Treasury
China’s and Japan’s central banks are massive holders of Treasury securities, with about $1.2 trillion each in July 2016, according to the U.S. Treasury. You can clearly see the trends of changing Treasury holdings on the above chart (data available only through July-2016). China’s Treasury holdings have been gradually declining in the past three years, and fell sharply in July-2016. After falling in 2014-15, Japan’s Treasury holdings rose this year (the yellow line), which offset China’s selling. But as the yen falls back from the 100 Y/$ level, the BoJ steps away from the FX market, and both China’s and the UK’s selling of Treasuries to defend the plunging sterling go in the same direction. This is what happened so far in October.
Rising inflation and FX market trends 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 the short term, my sense is that 1.80% on the 10y Treasury is critical level to watch– if it doesn’t hold, then it may jump to 2% quickly. This is probably the baseline, most likely scenario.
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