U.S. government bonds are paying more than debt from other developed countries for the first time in almost two decades, a new sign of investors’ struggle to reconcile expectations for faster U.S. growth with concerns about the impact of deficits and inflation.
The yield on the benchmark 10-year Treasury note, a key barometer for borrowing costs for consumers and companies, last week topped 3.1%, its highest close in almost seven years. It’s a climb that’s rippling through markets, buffeting stocks and helping fuel a surprise rally in the dollar as higher rates attract yield-seeking investors to the currency.
Analysts said the rise in yields in part reflects optimism about the U.S. economy and expectations for a pickup in inflation, which threatens the value of government bonds by eroding the purchasing power of their fixed payments. A market-based measure of expectations for annual inflation over the next 10 years, known as the break-even rate, recently reached its highest levels since 2014.
The climb also shows the impact of the recent tax cut package and a surge in government spending. Those have boosted short-term growth expectations while increasing borrowing and the supply of Treasury bonds, which can hurt bond prices. That comes as the Fed has raised interest rates in recent years and begun paring bond holdings accumulated during the financial crisis, unwinding stimulus policies like those that continue to keep rates low in many other countries.
“The U.S. has the highest rates of everyone in the G-10 and it looks like the rate differential will continue to widen,” said Chris Gaffney, president of EverBank World Markets. “The U.S. seems to be going it alone in this rising interest-rate path.”
The 10-year yield’s surge this year has pushed it above yields on bonds from seven major developed countries for the first time since June 2000, according to an analysis by Bianco Research. It recently exceeded the yield on 10-year debt from a record number of countries, according to Deutsche Bank Research, and surpassed the 10-year German bund yield by the most in almost three decades.
At the same time, economic data throughout much of the world has failed to meet expectations, eroding support for bets that the euro, yen and other currencies would rise versus the dollar. While investors speculate about the Fed increasing its pace of monetary tightening, they have also reduced their expectations for tighter monetary policies in Australia, Canada, the U.K., Japan, the euro-zone and other economies.
Higher Treasury yields are pushing investors back to the dollar, after they crowded into bets that the euro would rise versus the U.S. currency. As economic data has weakened in Europe, pushing yields down even as monetary policy remains accommodative, signs of employment and inflation growth U.S. have persisted, lifting Treasury yields higher. That shift has squeezed some investors, leading many to exit the trade.
Investors say they are also looking at the yield differential because the gap has made it increasingly expensive for money managers in Europe and Asia to buy U.S. government and corporate bonds. Those investors are increasingly looking instead to buy debt in Europe, where hedging costs are not a problem. This dynamic could make borrowing more expensive for U.S. consumers and businesses, and act as a check on growth.
Yields have surged along with bets that the Fed will speed up its pace of interest increases, adding to the three that officials forecast at their December and March meetings. That has raised concerns that policy makers, in their zeal to cool inflation, may prematurely tip the economy into recession.
Fed officials raised interest rates in March and penciled in two more increases this year. Fed funds futures, used by investors to bet on central bank policy, late Friday showed a 50% probability that officials raise rates four times. That contrasts with the situation in Europe where policy makers have yet to commit to ending bond purchases this year, and the time table for raising interest rates from their current level of minus-0.40% remains uncertain.
The expectations for further rate rises has driven up the yield on two-year Treasurys, which tends to move along with the direction of Fed policy. That’s narrowed the gap with longer-term rates, known as the yield curve. The curve, which many investors use as a signal of economic health, has been flattening lately, as expectations for longer-term growth and inflation remain tepid. Many investors are concerned the two-year yield could eventually exceed the 10-year yield, a phenomenon known as an inverted yield curve which has preceded every U.S. recession since at least 1975.
A Wall Street Journal survey of economists shows 59% of those surveyed expect the economy to enter a recession in 2020, while 22% foresee a contraction in 2021.
There are few signs of recession now, though some investors are concerned that wage growth has been slow even as the unemployment rate has fallen to its lowest since 2000. BNP Paribas forecasts the $1.5 trillion tax cuts will add a mere 0.5% to economic output this year and some investors have expressed concern that companies have devoted more of the proceeds to buying back their stock than to raising worker wages.
“It generates asset [price] growth but doesn’t necessarily generate economic growth,” said Alvise Marino, a currency strategist with Credit Suisse Group.
There’s little on the horizon threatening to change the dynamic of robust expansion in the U.S. and “stagnant” growth in Europe, said Luke Hickmore, a senior investment manager at Aberdeen Standard Investments. He said the dollar could gain another 5%-10% on top of the 5% it’s gained since February. “There’s no way the dollar’s stopping,” Mr. Hickmore said.
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Monthly perspective of UST10Y
