Oct 01, 2021 Macro

Bond market conundrums

Recent movements in 10-year Treasury yields has caught the market by surprise.

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Listen to the bond market, old hands on Wall Street are fond of saying. When it comes to the direction of the U.S. economy, the collective wisdom of fixed income traders tends to be more reliable than professional economic forecasters.[1] Alas, it is not always easy to understand what the bond market is saying.

Take the rise in 10-year Treasury yields, which accelerated sharply following last week's Federal Open Market Committee (FOMC) meeting. An open-and-shut case, it would seem: it’s the U.S. Federal Reserve's (Fed's) fault, for announcing it might taper its asset purchases a little sooner than expected. Except that this should mainly have been reflected in short yields rising too, due to the increased likelihood of earlier rate hikes. Instead, yields on 2-year Treasuries have risen moderately in comparison.

So, what is going on? Well, nominal bond yields can be decomposed, notably into real yields and inflation expectations. As our Chart of the Week shows, nominal 10-year Treasury yields and inflation expectations, as measured by break-even inflation rates, went up in tandem, from the summer of 2020 to March of this year. At the time, real yields, while still in deeply negative territory, went up too. All of which would be consistent with a booming U.S. economy as reopening proceeded.

After the FOMC meeting, the market started to discount both an earlier end to bond purchases, as well as earlier rate hikes. In addition, inflation expectations have increased, albeit contributing less to the rise in overall yields compared to the increase in real yields.

Nominal 10-year US Treasury yields, inflation expectations and real yields

20211001_CotW_U.S. Treasury_CHART_EN.png

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 9/28/21

Could other factors, such as the issuing schedule of new Treasuries, be drivers as well? Perhaps in part, though you might generally expect rational market participants to price in such factors ahead of time. Maybe, the bond market has been caught off guard by the headlines out of Washington about the political fights surrounding the debt ceiling and the budget resolution? Well, if anything, the signs are now for a smaller spending package, hence less issuance and lower yields than it seemed likely a few weeks ago. As for the debt ceiling the costs of insuring against the U.S. government defaulting indeed went up a little in mid-September – but only by a few basis points and well before those scary headlines. In short, the riddle remains, at least for now.

"In any case, we have been expecting a rise in yields for quite some time now. Hence, the recent market move fits well to our strategic view", explains Dr. Jörn Wasmund, global head of fixed income at DWS.

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