Is the recent dip in Treasury yields a cause for concern?
The world’s most important bond market is relaying somewhat confusing signals. After reaching a pandemic-era peak of 1.74 percent at the end of March, the yield on the benchmark 10-year U.S. Treasury note has fallen sharply (it has been stuck below 1.3 percent in recent weeks). Given the surge in reported inflation in recent months and forecasts of above-trend U.S. GDP growth in 2021 and 2022, the decline in bond yields poses a bit of a conundrum.
Prior to an examination of recent bond market volatility, it is necessary to grasp the broader significance of the U.S. Treasury securities market. It plays an outsized role in domestic and international financial markets. As Treasury securities are backed by the full faith and credit of the U.S. government, they are typically viewed by financial market participants as (default) risk-free assets. Furthermore, the U.S. Treasury securities market is the most liquid and most active bond market in the world. Given these inherent qualities, the yield-to-maturity offered by a comparable maturity Treasury security is often used by investors as the benchmark interest rate for comparing returns on more risky assets.
Recent behavior of the government bond market has puzzled many and created considerable uncertainty regarding the near-to-medium term outlook. After rising sharply during the first quarter of 2021, the yield on the benchmark 10-year U.S. Treasury note has tumbled of late, briefly dipping below 1.2 percent on July 19. Current expected real return on a 10-year U.S. Treasury note is substantially negative.
Does the decline in long-dated Treasury yields and significantly negative real interest rates portend an early end to the so-far promising pandemic recovery growth story? Is the bond market right in its conviction that ongoing inflationary pressures are mostly transitory?
A slew of less-than-convincing explanations offered up by market participants and economic commentators has only added to the puzzle. The rapid spread of the delta variant of the COVID-19 virus has led some to fear a possible slowdown in economic activity as some restrictions are reimposed and others are maintained for longer than previously anticipated. While the resurgence of the virus may pose some temporary challenges, it is quite unlikely to derail the economy or even significantly slow down the pace of the U.S. economic recovery. Widespread availability of effective vaccines and the slow but inevitable shift towards vaccine mandates imply that a replay of the events of 2020 is unlikely.
A more intriguing explanation revolves around evolving expectations regarding the Federal Reserve’s future behavior. Some bond traders are now assuming that the Federal Reserve (the Fed) will be more aggressive than previously thought as pressure mounts on the central bank to act on rising inflationary concerns. This frankly appears to be a somewhat misguided concern — the plodding approach of the Fed led by Chairman Jerome Powell suggests that the U.S. central bank is more likely to be behind the curve in its battle against inflation. Tapering of bond purchases and eventual interest rate hikes are likely to be carried out in a very gradual manner, especially given the recent adoption of an average inflation targeting framework by the Fed.
There is also a distinct possibility that the bond market is misreading the inflation signals. The ongoing buildup in pricing pressure is likely to persist into 2022 and beyond as widespread supply constraints crimp productive capacity worldwide even as global demand remains robust. Furthermore, many of the structural forces (globalization and the emergence of international supply chains centered around China; technological changes that led to the growth of e-commerce and increased price competition; and demographic shifts that saw a dramatic rise in the global working-age population) that kept a lid on inflation over the past three decades may now be starting to work in the opposite direction and leading us into an era of higher trend inflation.
In this environment, bond yields that are so low as to guarantee a negative real return if the securities are held until maturity may appear puzzling or downright odd. Furthermore, with budget deficits expected to remain high for the foreseeable future, can demand for U.S. Treasuries remain strong even as supply surges?
Treasury bond market dynamics are complicated by several factors. First and foremost, the Fed is a sizable actor in the Treasury market (the value of its government bond holdings now exceeds $5 trillion dollars), and its role is growing as it continues to add to its portfolio. Japanese and European investors, facing negative nominal yields at home, continue to find the meager yet positive yields offered by U.S. Treasury securities relatively attractive. The U.S. dollar’s status as the pre-eminent global reserve currency also generates demand for U.S. Treasuries from foreign central banks seeking to replenish their foreign reserve holdings.
Still, for domestic bond investors, current yields may not offer sufficient compensation for future inflation risks. Many bond traders may in fact be engaged in short-term speculation motivated by some version of the “Greater Fool Theory.” Essentially, investors are willing to pay a high price (the price of a bond and its yield are inversely related) at present in the hope that someone else will come along shortly and offer an even higher price for the bond.
It is hard to justify today’s ultra-low yields on long-dated Treasuries based on fundamentals unless we are headed for a period of dramatically weaker growth that is accompanied by extremely low inflation, an outcome that appears unlikely. Rationally, we should expect yields to rise going forward.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.
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