Volatility remains high in US Treasury bond markets following the surge in yields since July. Having only recently breached the level of 5%, the yield of the 10-year US Treasury bond fell back this week to around 4.72%. In our view, the tide is turning in favour of sovereign bonds.
Sovereign bond yields buffeted by numerous forces
Yields of US Treasuries, which affect the level of longer-dated interest rates in other developed sovereign bond markets, have been buffeted by several forces in recent weeks. Exhibit 1 shows our fixed income team’s scorecard for the different factors pulling yields of US Treasuries up and down.
Looking at the scorecard, we see the following factors now gaining the upper hand:
Supply of US Treasuries – Less than expected?
Changes in US debt management policy are generally informed and communicated by the US Treasury through the quarterly refunding process around the middle of each calendar quarter. The Treasury’s announcement on 2 August of a significant rise in the issuance of bonds in the fourth quarter of 2023 was one of the factors that triggered the surge in 10-year Treasury yields to 5% in late October.
On Wednesday, the Treasury said that according to its projections, the recent flood of new long-dated debt supply should slow in coming months.
Bond markets rallied hard on the view that a slowdown in issuance will occur in two distinct ways:
First, according to the latest quarterly refunding materials, auctions of 10-, 20- and 30-year Treasuries will be smaller than had been anticipated.
Second, the Treasury said it sees an end to the growth in auction sizes with just one further quarter (starting April) of increases in issuance of longer-dated debt.
With US fiscal deficits relatively high, markets appear to have taken the view that the news on forthcoming issuance could have been a lot worse.
Signs of faltering US growth
Wednesday’s publication of the Institute of Supply Managers’ (ISM) manufacturers survey brought surprisingly downbeat news. As one of the best leading indicators for growth, this survey matters and contributed to this week’s rally in US bond markets.
The ISM’s decline was unexpected. It fell to 46.7 in October from 49.0 in September, with the new orders component down to 45.5. This fall undoes the improvement seen in the last few months. In our view, this report shows the clear impact of the auto workers strike and a slower recovery in manufacturing going forward than previously thought.
Commentary in the ISM release points to a weaker view of the present and less optimism for the future, in line with consumer sentiment measures for October.
The sentiment expressed by one chemicals producer in the report reflects the view of our multi-asset team: “Economy absolutely slowing down. Less optimism regarding the first quarter of 2024.”
Similarly, the employment component of the ISM survey dropped by over four points, suggesting that the strength in manufacturing jobs seen in recent non-farm payrolls reports may not continue when the employment report for October is published on 3 November.
A balanced message from the Fed
As expected, the US Federal Reserve left policy rates on hold at 5.25-5.50% at its penultimate meeting of 2023 (the final meeting is on 12/13 December).
There was little noteworthy news in either the statement or during Chair Jerome Powell’s press conference. Powell left a nominal tightening bias in place, acknowledging the strong growth in the third quarter and the continued strength in the labour markets.
Overall, the impression remains that policymakers expect, over time, tighter financial and credit conditions for households and businesses to achieve the Fed’s objective by weighing on economic activity, hiring, and inflation.
Bank of Japan dismantles yield curve control
This week, the Bank of Japan (BoJ) took a significant step toward ending its 7-year policy of capping long-term interest rates, extending the gradual dismantlement of its massive and long-standing monetary easing measures as it sharply raised its inflation outlook.
The BoJ’s policy board on 31 October decided to allow yields on the 10-year government bond to rise above 1%, revising its so-called yield curve control policy for the second time in three months. More precisely, the 1% top level for the 10-year yield is now a ‘reference point’ rather than a strict limit.
Bank of Japan governor Kazuo Ueda said the main factor driving the decision was the recent larger-than-expected rise in US Treasury yields.
A weak yen, rising Japanese bond yields, and persistent inflation have put pressure on the BoJ to unwind core parts of its stance. The central bank maintained its policy rate at -0.1%. It also revised its inflation forecast significantly upward, saying it expected a 2.8 % core inflation in the 2024 fiscal year, instead of its previous forecast of 1.9%.
Higher Japanese bond yields and the weak yen make it less attractive for Japanese investors to seek better returns overseas by buying, for example, US Treasuries – a factor potentially putting upward pressure on US bond yields on our scorecard.
Mild GDP contraction in the eurozone
Turning to the eurozone, where a rise in yields of German Bunds has been partly driven by the rise in US Treasury yields, there was positive news for bonds.
Recent GDP and inflation data reinforce our confidence that the European Central Bank has reached the terminal rate in this hiking cycle.
The preliminary figure for GDP growth in the third quarter indicated the economy contracted by a mild 0.1% quarter-on-quarter (QoQ), slightly below the flat number the consensus expected.
Overall, the broad picture remains that of a stagnant economy rather than a prelude to a fully-fledged recession.
Furthermore, it is worth highlighting that a contraction of 1.8% QoQ in Ireland – where data are usually volatile and do not necessarily reflect the underlying economic environment – has likely biased the aggregate picture, shaving off around 0.1% from the headline figure. Controlling for the Irish data would imply a flat GDP growth figure for the eurozone as a whole, i.e., just in line with the ECB’s forecast and the average growth rate in the eurozone’s major economies.
It does appear that another quarter of stagnation is underway in the eurozone: Our macroeconomic team expects the region to avoid recession, with activity stagnating in the fourth quarter for a full-year 2023 growth rate of 0.5% year-on-year, followed by 0.2% in 2024.
Eurozone inflation falls below 3%
The improvement in preliminary eurozone headline inflation data for October is encouraging and slightly larger than had been expected. The headline Harmonised Index of Consumer Prices (HICP) fell in October to its lowest level since August 2021, from 4.3% month-on-month in September to 2.9%, which is below Bloomberg consensus expectations of 3.1%.
The data has been flattered by energy price base effects as energy inflation spiked 6.6% MoM in October 2022. There was probably a dip in fuel prices at the pump last month, as crude oil prices dipped in the first week of October before the start of the conflict in the Middle East.
Weakness in food inflation – which fell to its lowest level in 17 months – contributed to the drop in headline inflation. Though food prices are erratic, this could be part of a trend as food inflation may be benefiting from the moderation since the start of 2023 in the prices of agricultural commodities and energy, which are still being passed through the food supply chain.
Underlying inflation pressures are gradually softening too as the more important core reading was also lower on the month, from 4.5% in September to 4.2% in October. While core pressures have eased, they remain too high for the ECB’s comfort, suggesting to us that the ECB will not cut policy rates before the second quarter of 2024.
At face value, it can be hard to reconcile the slowdown in eurozone core inflation with still tight labour markets and fast wage growth. Further declines in services inflation will rely on easing wage pressures. While it may be that wage growth has effectively peaked, the deceleration in wage growth might be slower than expected. Indeed, workers could use their relatively high bargaining power at present to secure significant nominal wage increases to make up for purchasing power lost.