Is it time to buy long-term U.S. government debt–after the recent selloff weighed on prices and pushed up yields? Not yet, we think. Interest rate expectations and rising Treasury issuance could keep upward pressure on long-term bond yields, while an asymmetric risk and reward dynamic makes the short-term bonds relatively more attractive. Our preference to short-term government bonds also extends beyond the U.S.
We look at two key drivers behind the rise in government bond yields in four key developed economies: real yields (nominal yields minus the rate of inflation, in light blue) and inflation expectations (in dark blue). Real yields typically rise when the economic growth outlook improves. In the U.S., rising real yields have contributed to the bulk of the increases in both 2-year and 10-year bond yields in the selloff over the past few months. See the chart above. Our BlackRock GPS suggests that consensus estimates for U.S. growth may still be too low. And the market is adjusting to the Federal Reserve’s recent rhetoric suggesting a potentially higher terminal federal funds rate (the peak Fed rate in this hiking cycle). Real yield increases have also contributed to the bulk of the rise in Japan’s 10-year bond yield, while rising inflation expectations have been the main driver of yield changes in Germany and the UK.
Our rate view
The market is pricing in about three Fed rate increases over the next 12 months, in line with our view. Changes in rate expectations are typically reflected in short-term government bond yields. Yet the front end of the U.S. yield curve has already priced in a reasonable amount of Fed tightening. Rising rate expectations are now lifting yields on the long end of the curve as terminal rate assumptions adjust higher. The growing U.S. budget deficit will lead to greater Treasury supply, potentially putting further upward pressure on yields. Even as real yields and the term premium (the compensation for owning longer-dated bonds relative to shorter-dated ones) have risen, investors in longer-dated bonds aren’t yet being adequately compensated, in our view. The 10-year term premium is close to zero or even negative by some measures. We expect a further modest rise in the U.S. 10-year yield toward the top of a 3%-3.5% range–but not much further–over the next six months, as the market weighs Fed actions and the impact of U.S. fiscal stimulus. Yet any growth scares could spark demand for perceived safe havens such as U.S. Treasuries and weigh on yields.
We still prefer shorter-term sovereign bond exposures globally for now. The relatively flat yield curve in U.S. Treasuries presents an asymmetric risk-and-reward dynamic: Short-term U.S. Treasuries today provide 90% of the yield earned on long-term ones, with far less exposure to the risks associated with holding the latter. They also offer potential price upside if the Fed pauses on its normalization path. Yield curves in Europe and Japan are somewhat steeper than in the U.S., yet we still generally prefer the short end because central banks in those countries have yet to start normalizing their monetary policies.
We believe it is too soon to add significant exposure to longer-term global government bonds other than in selected areas such as longer-term tax-exempt U.S. municipal bonds. Currency dynamics are making European bonds more appealing for global investors despite their low headline yields. Conversely, higher U.S. yields are largely wiped out by the cost of hedging for euro- or yen-based investors, making domestic fixed income look more attractive. Overall we still see scope for long-term yields to rise in all regions.