Global bond markets continued their sell-off this week, pushing borrowing costs to their highest level in a decade or more. Rising interest rates, high oil prices, and a stronger dollar are a potential recipe for a harder landing for the US economy than anticipated.
Longer-dated sovereign bond yields continue to rise
US 10-year Treasury yields reached 4.88% this week, their highest level since 2007 and up by around 100 basis points relative to their level in July. In just the last two weeks, the yield on the benchmark US 10-year bond has risen by some 50 basis points as part of a comprehensive shift in longer-term rates. From an inversion of the US yield curve of around 108 basis points (the extent to which 2-year yields exceeded 10-year yields)as recently as July, the difference has fallen to 32 basis points, the least inverted the yield curve has been in almost 12 months.
German 10-year Bund yields rose as high as 3% this week before falling back. The rise in bond yields has been driven primarily be rising real yields. US real 10-year yields surged to 2.325%, their highest since 2008 (see Exhibit 1).
Much debate what the factors driving bond yields higher
Global government bond supply remains historically high. In the US, fiscal deficits, already unusually high at this stage in the cycle, may well continue to widen as a loss in growth momentum leads to weaker tax revenues.
In Europe, ongoing fiscal deficits coupled with a possible acceleration in the European Central Bank’s quantitative tightening programme will likely keep net supply volumes at elevated levels.
Uncertainty around neutral policy rates has renewed conviction that while central banks may not have to raise policy rates further, they will at least need to hold them at elevated levels for longer. Policy rates above yields on long-term government bonds may deter investors from stepping in to buy duration.
And as for global liquidity
Global central bank excess reserves are likely to go on declining into year end and 2024. In the US, quantitative tightening remains underway and is expected to continue into 2025 despite rate cuts.
In the eurozone, it is probable that the unwinding of the balance sheet will accelerate, with the European Central Bank opting to end Pandemic emergency purchase programme (PEPP) reinvestments early in 2024, rather than turning to active sales of asset purchase programme (APP) holdings.
Finally, the Bank of Japan is still constrained by current forward guidance on inflation and is unlikely to turn to balance sheet normalisation until after the first policy rate hike, which may come in the second quarter of 2024.
US government shutdown averted, for now
A compromise was reached to keep the US government open until 17 November. This temporarily avoids the immediate threat of another (albeit moderate) headwind to US GDP growth; moreover, US economic data will be released as normal. That said, the removal of House speaker Kevin McCarthy will mean the work to pass legislation before the 17 November deadline will stall and raises the risk of a shutdown at this later date.
All eyes on the US job numbers
Developments in the job market remain crucial in determining the outlook for the US economy. The consensus expects an increase of 150,000 in nonfarm payrolls in September, which would be the weakest in three months. This comes off the back of an unexpected jump in the JOLTs job openings; this was concentrated in the professional and business services sector. As a result, the openings-to-unemployed ratio – a key Fed metric of job-market imbalance – held at 1.5 in August, still above pre-pandemic levels. Progress towards rebalancing has not been as good as we thought.
Higher rates start to bite
The Dallas Fed’s September Banking Conditions Survey showed credit still tightening at a slightly more intensive pace than in August. Loan demand continued to decline and loan non-performance rose. The Fed’s broader Senior Loan Officer Opinion Survey will be released on 6 November.
Oil prices, starting to feel stronger macroeconomic headwinds?
Oil prices had risen to around USD 90/barrel, up by more than 25% since June. They appeared to be heading for a level of USD 100/barrel but fell back this week, perhaps due to concerns that the sharp increase in borrowing costs will dent economic growth.
The stagflationary consequences of the recent rise in oil prices provide support to the notion that central banks will pursue ‘high-for-longer’ policies. Our macroeconomic team still see both the Fed and the ECB beginning to cut rates from the middle of 2024, but higher headline inflation due to the spike in oil prices reduces the chance of an earlier move. In fact, if there is evidence that higher oil prices are fuelling a rise in inflation expectations and leading to second-round effects in core inflation, further rate hikes could be back on the table.