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Weekly investment update – A (real) conundrum in G7 government bonds

Breakeven yields in G7 sovereign bond markets have risen sharply recently in reaction to supply-side shocks and the spike in energy prices. Nominal yields have risen by less, buoyed by central bank liquidity. Real yields, though, are a conundrum at or near record lows in Europe and the US. What’s the message? Is there a message?

It’s not easy to kick-start a global economy

Restarting a stalled global economy is proving an awkward exercise. Untangling disrupted supply chains is turning into a long-term rebuilding and rethinking exercise. Manufacturing capacity in China remains a potential source of further supply side shocks if its zero-Covid policy results in widespread shutdowns.

The recent spike in natural gas prices has revealed an unknown unknown – the potentially inflationary nature of the energy transition from fossil fuels to sustainable power. Meanwhile, the risk of an excessively hard winter loiters in the background – a known unknown.

And then there are labour markets

Wage inflation would mean smouldering inflationary risks were really igniting. Only in the US does this seem possible in the short term. Will workers return to the job market now that pandemic-era federal government benefit programmes are being wound down? Is organised labour going to make a comeback with Joe Biden’s help in the post-Covid era?

From what we have seen so far, it does not seem that the reopening of schools and, in the US, the termination of supplementary unemployment support have triggered an immediate jump in labour force participation. This is despite record job openings. Anecdotal reports suggest companies are already adapting by paying up to cover labour shortages.

And what exactly is meant by transitory?

Overall, it has become clear since September that US and global inflation pressures are more than simply temporary in the sense of a 3-6 month transition. The term ‘transitory’ is now interpreted as meaning 12-24 months, maybe 36 months.

That is a long enough period to potentially de-anchor inflation expectations from central bank inflation objectives, forcing monetary policy responses.

In short, the whole transitory thesis is being given a thorough stress test. Particularly in the US where recent data suggests inflationary forces are gathering momentum.

Speaking after the meeting of the ECB council on 29 October, ECB President Christine Lagarde stuck to the narrative that the near-term rise in inflation is transitory. We would expect a similar message from Federal Reserve policymakers after the meeting of the Federal Open Markets Committee on 2-3 November.

Some central banks, however, are reacting to higher energy prices and supply bottlenecks. On 27 October, the Bank of Canada surprised markets by announcing it would stop asset purchases and raise interest rates sooner than expected. On the same day, Brazil’s central bank raised rates by 1.50%, marking its biggest move in almost 20 years.

The reaction in government bond markets

Sovereign bond markets in the US and eurozone have priced this period of rising inflationary pressure via higher breakevens (see Exhibits 1 and 2 below). The prospect of higher energy prices weighing on the outlook for growth may be part of the explanation for low/lower real yields.

The chart shows changes in 10-year Treasury nominal yields, 10-year breakeven spread and 10-year real yields for year to date
The chart shows changes in 10-year Bund nominal yields, real yields and breakevens for year-to-date

The conundrums in sovereign bond markets

Given what can be considered a sea change in inflation expectations, there are a number of conundrums:

In our view, the resilience of US Treasuries in the second and third quarter was, frankly, difficult to explain. Why did yields not rise by more?

Although the pace of the output and employment recovery was perhaps somewhat slower than had been anticipated, every indication was that this was due to supply side considerations rather than a shortage of demand. In the meantime, those supply constraints were contributing to a surge in inflation.

Among the possible explanations are the following issues: 

  1. Crowded positioning in reflation trades
  2. Limited net supply of US Treasuries as the Treasury had pre-funded much of its financing requirement in 2020 – meaning the Treasury was able to draw on an enormous USD 1.8 trillion cash balance at the Fed
  3. US pension fund rebalancing needs away from equities, moving into US Treasuries
  4. Heavy buying of US Treasuries by banks given weak growth in their loan books and the launch of new repo facilities for dealers at the New York Federal Reserve 
  5. Relatively high FX-hedged yields on Treasuries for international investors. 

Why are real yields so low?

The fall in real yields this summer may be due to investors reacting to the prospect of inflation by buying inflation-linked bonds. Not necessarily the optimal hedge as detailed in this post.

In the short term, returns of inflation-linked bonds are driven by the instantaneous repricing of real yields. Linkers held to maturity will compensate for the realised inflation as it occurs over the life time of the bond through a slow accreting process. 

Real yields – A negative view on the outlook for growth

Pessimism about the prospects for growth longer term may be reflected in low real yields. Higher energy prices are simply adding a further drag on growth (the ‘stag’ in stagflation). 

The US GDP data published on 29 October showed the economy expanded by just 2% on an annualised basis in the third quarter. This was below consensus expectations for 2.7%. This is a significant slowdown from the 6.7 % pace in the second quarter. Likely explanations include the negative impact of the resurgence of Covid cases and weaker demand due to higher inflation caused by supply chain issues.  

And lower for longer

Demographics are reversing in a number of countries (not least in China), savings rates are likely to decline over time, and pension and healthcare systems will suck up resources. In addition, the potentially inflationary nature of the energy transition from fossil fuels to sustainable power is now being integrated into the equation. 

Trend economic growth will slow further given the population trends, but economies may well operate closer to full capacity. Policymakers could be incentivised to reduce heavy debt burdens through an inflation tax. Central banks will have the difficult task of controlling its level.

Since inequality has rendered austerity politically unacceptable, and since real yields must be repressed for debt sustainability reasons, central banks may need to remain the marginal buyers of government debt.

The risk is that at some point, this currency seigniorage will devalue some currencies and further contribute to inflationary pressures in certain economies.

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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