What’s driving up US Treasury bond yields?

THE 10-year US Treasury bond yield recently reached its highest level since October 2007, rising to as high as 4.69 per cent.

Ten-year yields have risen by more than 60 basis points (bps) in just two months, weighing on the performance of equity markets, with the S&P 500 down more than 7 per cent from its July peak.

Although there are clear signs of US core inflation moderating, markets remain unconvinced that interest rates have peaked. US labour markets remain strong due to a confluence of factors, hence the higher-for-longer interest rates.

Back in March, the Federal Reserve thought US unemployment would hit 4.5 per cent by the end of this year, well above the current level of 3.8 per cent. And despite hiking rates to between 5.25 per cent and 5.5 per cent, the labour market’s persistent strength has surprised economists at the Fed and those on Wall Street, whose earlier predictions of recession have largely been disavowed.

The US labour market has been rather resilient, thanks to strong private consumption which has held up remarkably, due to the generous Covid-19 fiscal stimulus that helped low and medium-income Americans. Wealth among the lower 50 per cent of American families has increased by nearly 75 per cent from the first quarter of 2020.

Demand for workers has also been strong due to the small business sector. Concerns in March that a tightening of lending standards – sparked by stress in US regional banks – would hurt small businesses seem overdone. After levelling off in 2022, new-business applications are up again year to date, and are 55 per cent above February 2020 levels, fuelling further demand for labour.

A strong labour market and the ensuing recovery in real wages mean real disposable income growth remains positive.

In addition, household balance sheets are much stronger. US households’ net worth is at least 30 per cent higher than pre-pandemic. The Fed’s easy monetary policy triggered a massive rally in financial asset values. Corporate America is largely sheltered from the prevailing high interest rates, as most corporates refinanced their debt at lower rates before July 2022, when the Fed started hiking rates aggressively.

US households are also hedged against interest rate risks to a great extent; 85 per cent of US home mortgages are fixed-rate mortgages with maturities of up to 30 years. Higher interest rates do not affect the cash flow of households with fixed-rate mortgages locked in before July 2022.

In contrast, in countries such as Australia and the UK, the proportion of adjustable-rate mortgages is larger and therefore higher interest rates have a significant negative impact on the cash flow of households, thereby affecting consumption.

A more sinister explanation for the sharp rise in US Treasury yields is that the sell-off in the bond market is not just due to the higher-for-longer narrative, but also because of the relentless ramp-up in US Treasury borrowing to fund fiscal expansion, combined with potentially lower demand for the Treasuries. Another US$567 billion will be issued by the US Treasury this year, compared to the US$475 billion already issued in the first eight months of this year.

The US federal deficit has never expanded so rapidly when the economy has been so robust. The federal deficit is likely to double to 7.5 per cent of gross domestic product (GDP) from a year ago.

With US presidential elections in a year and the deep polarisation in US politics, improvement in the fiscal situation is unlikely. If anything, deficits are likely to deteriorate given the higher interest expenses. Deficits do matter, now that the level of debt has risen past the size of the US economy and the US Treasury can no longer borrow at near-zero rates.

The higher risk premium that the market is asking to finance the US deficit could trigger a sharper slowdown as higher interest rates start impacting the rollover of corporate debt, investment and consumption. There will also be added pressure from foreign institutional investors, especially Japanese institutions who collectively hold around US$1.2 trillion in US Treasuries.

With monetary policy gradually tightening in Japan vis-a-vis the repricing of the Bank of Japan’s yield curve control strategy, the yield gap between US Treasuries and Japanese government bond yields will likely narrow, thereby lessening the appeal of holding US Treasuries.

Furthermore, most foreign institutional investors are already holding a lot of US Treasuries and sitting on hefty losses, after an estimated 20 per cent fall in prices between early 2022 and today. The US government avoiding a shutdown at the eleventh hour over the weekend – and only for 47 days – does not help investor confidence.

But the acid test of whether supply concerns are driving the sell-off in US Treasuries will only come when it is possible to see how US Treasury prices react to any sudden weakening in US data, most particularly employment data and GDP growth. Bond prices tend to react positively to weakening macroeconomic data, and vice versa.

In this respect, US nominal GDP growth is slowing this year and worryingly, Treasury bond prices have not rallied. US nominal GDP growth slowed from 7.1 per cent year on year in Q4 2022 to 5.9 per cent year on year in Q2 2023, while the 10-year US Treasury bond yield is up 72 bps year to date.

When prices of US Treasuries cease to be inversely correlated with nominal GDP growth, the financial markets will likely be in for gut-wrenching changes.

The writer is the chief investment officer for south Asia-Pacific at UBS Global Wealth Management