This summer, historically low equity market volatility is grabbing all the financial headlines. What is less remarked on is the bond market. Treasury market volatility remains similarly constrained, with yields stuck at around 20 basis points (bps, or 0.20%) below where they started the year.
Back in early May I wrote about the yield “melt-up” that wasn’t. At that time the thesis was that a combination of steady but uninspiring growth, moderating inflation and lower yields elsewhere would keep interest rates contained. Three months later it looks like little has changed.
Inflation refuses to accelerate
Inflation expectations have rebounded over the past six weeks but remain well below the January peak. This reflects a further deceleration in realized inflation, particularly core. Since January, U.S. core Consumer Price Index (CPI) has fallen from 2.3% to 1.7%. At the same time, despite a strong labor market, wage growth remains stuck at around 2.50%.
Growth is solid but not breaking out
Second quarter gross domestic product (GDP) evidenced the now familiar rebound. That said, while the U.S. economy is on solid footing, it has disappointed relative to expectations. The Citigroup Economic Surprise Index, which measures how actual economic data releases compare to expectations, remains in negative territory, albeit above the June lows (see the accompanying chart). Economic data has been unable to match lofty expectations and the hoped for sugar rush from Washington via tax cuts is no closer to being delivered.
Citigroup U.S. Economic Surprise Index
The global yield picture still favors the U.S.
Yields of German 10-year bunds and Japanese government bonds (JGBs) are almost exactly where they were last spring, the latter being a function of central bank policy. With yields of 40 bps and 5 bps respectively, neither bunds nor JGBs offer much competition to the U.S. 10-year note. Of the world’s large, liquid sovereign bond markets, only Australia is currently offering higher yields.
Those still expecting a second-half rise in rates could rightly point to the pending reduction in the Federal Reserve’s (Fed’s) balance sheet. To be sure, to the extent quantitative easing reduced rates, logic dictates that its removal should lift them. The question is by how much.
Nobody has lived through a Fed balance sheet reduction, leaving its impact unclear. What is becoming obvious is that few feel a need to rush to the exits. Despite a well telegraphed campaign from the Fed, 10-year nominal rates, real rates and the term premium (a measure of compensation for taking on additional duration risk) remain at or below where they were in May.
Meanwhile, the various longer-term forces that have been constraining rates remain very much in place: an aging population, persistent institutional demand for long-dated assets and the disinflationary impact of technology. Moreover, it is worth observing that the slippage in yields has occurred against a backdrop of a strong bull market, one characterized by almost zen-like tranquility. Hedges have not been much in demand. Which leaves the question: What happens to bond prices and rates should investors ever want to start hedging again?