Bond market flashes mixed messages as real yields plunge

New York

Bondholders are increasingly willing to be paid less than nothing in the US Treasury market. With inflation expectations rising and nominal rates falling this week, so-called real yields on US government securities have dived even deeper below zero ahead of the latest consumer price index release on Wednesday (Nov 10).

The rate on 30-year inflation-protected securities, a measure of real yields over the next 3 decades, dropped to a record low of around minus 0.60 per cent.

Such a slide would usually suggest the bond market has a deeply pessimistic view of economic growth, anticipating that a slowdown would keep rates low in the years ahead. But the movements in the world's largest bond market now are defying such straightforward explanations as the US emerges from the worst economic effects of the pandemic.

Strategists said the slide in real yields also reflects other factors, such as traders re-positioning portfolios, and concern in some corners that the high rate of inflation will become ingrained in the economy.

Jerome Schneider, head of short-term portfolio management and funding at Pacific Investment Management Co, said the downward spiral in real yields is really about ginned up inflation expectations.

"Bottom line, if you believe that real yields are attractive here, it means that your view is that longer-term inflation stays pretty dang high for a long time," Schneider said.

He does not subscribe to that view, predicting that the rise in consumer prices will start to abate in the first quarter of next year. "Real rates will get less negative as inflation gets more in the area that the Fed is more comfortable with."

But so far, the bond market is pricing in more inflation risk, not less. Yields on 10-year Treasury inflation-protected securities, or Tips, have dropped to around minus 1.2 per cent.

That has widened the gap between those yields and those on normal 10-year Treasuries. That difference, a proxy of inflation expectations known as the break-even rate, has grown to about 2.64 per cent, up from around 2 per cent in early January.

Such negative real yields are not unique to the US, said Subadra Rajappa, head of US rates strategy at Societe Generale, noting that UK 10-year real rates have hit a record low. Australia's 10-year real yield dropped 8 basis points on Wednesday (Nov 10) in Sydney to minus 0.4 per cent, after briefly turning positive at the end of October.

Still, analysts say they have been exaggerated in the US by the Federal Reserve's Treasury purchases since the pandemic, though that will be less of a factor as the central bank winds down that buying.

Gary Pzegeo, head of fixed income at CIBC Private Wealth Management, is among those who see a mix of forces behind the fall in Tips yields, saying it is hard to nail down "one overarching theme".

"There is a negative message," said Pzegeo, whose firm manages about US$96 billion in assets. "There's low potential growth and high implied inflation, which absorbs what low nominal yield there is."

Traditional Treasury yields have joined the downward march since last week, in part due to traders unwinding their short bets and amid speculation that the Fed could take an even more dovish shift if President Joe Biden replaces Jerome Powell.

The wagers on Tips could pay off if inflation outpaces the market's current expectations. Were that to happen, even a buyer who purchased them at the current negative yields could profit.

The securities also provide minimum coupon payments in the interim. Yet Tom Porcelli, RBC Capital Markets' chief US economist, said the signal being sent by bond buyers is murky and out of synch with his expectations for both growth and inflation.

"It can't be a reflection of growth, because growth is quite strong and it's going not just this year but in 2022," Porcelli said. "Is it an inflation story? Inflation is going to slow down, there's no question about that. So, I don't know what you are left with - and that's the problem." BLOOMBERG