The incredible resilience of the U.S. economy, highlighted by September’s payroll numbers, has caused government bond yields to rise sharply. However, we believe the spike in yields is not driven chiefly by concerns over inflation or potential rate hikes by the Federal Reserve. Instead, it is driven by reduced expectations of recession, which counterintuitively could lead to an increase in the supply of government bonds in the future. As a result, investors are demanding a higher premium for holding longer-maturity bonds.

Steepening of the yield curve creates a compelling opportunity for investors in money markets to consider adding longer-duration assets, in our view. Starting yields are high relative to history and to other asset classes on a risk-adjusted basis. This can create a “yield cushion” amid a still highly uncertain outlook. In addition, bonds have the potential to earn capital gains and diversify portfolios. Indeed, investors can now seek to construct resilient portfolios, pursuing robust yields and predictable flows, with a moderate amount of risk.  

The spike in rates is also working to tighten financial conditions by making new debt much more expensive. This should eventually raise the cost of existing debt as fixed terms run out on loans to businesses and households. Higher yields have already contributed to stagnating flows of new loans this year. We believe this may eventually slow economic activity and moderate inflation enough for central banks to ease.

Investors demand higher yields to buy bonds

Paradoxically, yields have jumped despite developed market central banks having neared the end of their respective hiking cycles, and as headline inflation rates have moderated meaningfully. This has raised questions about the underlying drivers of the recent market repricing.

Consider that U.S. Treasury yields have risen and the yield curve has steepened with real rates – indicated by yields on Treasury Inflation-Protected Securities (TIPS) – leading nominal bond yields higher. By contrast, the spread between real and nominal rates, or the breakeven inflation spread, hasn’t changed much at all. This suggests that investors aren’t worried about inflation risks, but are nevertheless demanding a higher real term premium to hold longer-maturity government bonds.

Why would investors all of a sudden demand more real term premium? At the heart of it, we think it relates to a combination of factors that have recently shifted private investors’ outlook about future government bond supply. Expectations of greater supply have meant a higher yield required by the marginal investor. These factors include

1. More resilient economies and lower recession risks. This suggests that central banks can continue for longer to reduce their holdings of government bonds. The process, known as quantitative tightening or “QT,” tends to boost the supply of bonds in the market and tighten financial conditions. Earlier in the year, the U.S. regional banking crisis led to a steep drop in policy rate expectations and lower term premiums embedded in longer-dated bonds. Markets were pricing in the prospect of recession and policy easing, including a cessation of QT.
2. Resilience in developed economies outside the U.S. Importantly, this has reignited enough inflationary pressures in Japan for its central bank to ease away from its yield curve control policy. Over the past decade, the Bank of Japan (BOJ) has been an important source of demand for Japanese Government Bonds (JGBs). This crowded out Japanese domestic investors from their local bond markets, increasing demand for global bonds. Now that the BOJ is easing away from these policies, there should be more JGBs for the private sector to buy to finance Japanese government deficits – thus reducing demand for Treasuries.
3. The outlook for the U.S. deficit has also been ratcheted up. In particular, there have been growing concerns over the future cost of government tax credits and subsidies related to green energy investments. In May, the Congressional Budget Office (CBO) revised higher its 10-year outlook for costs stemming from last year’s Inflation Reduction Act – the largest-ever investment into addressing climate change. Private forecasters have asserted that because these new government incentives are uncapped, even the CBO’s latest estimates may be grossly underappreciating longer-term costs. That could require increased issuance of Treasuries.

These factors have raised fresh questions about U.S. debt sustainability. Government debt loads have gotten more expensive to service as interest costs rise amid moderating nominal growth. Concerns about debt-sustainability were exacerbated by Fitch’s downgrade of the U.S.’s sovereign credit rating to AA+ from AAA in August. However, the spread between Italian government bonds and matched-maturity German bonds has also widened in Europe as investors grapple with debt-sustainability questions there. 

Investment implications

The normalization in the shape of the yield curve and repricing of real yields reflects investors’ demand for higher yields in the face of greater supply. However, what’s good for investors is not necessarily sustainable for the economy over the medium term. Higher rates have further tightened financial conditions, which should weigh on investment, real GDP growth, and eventually inflation. In other words, higher yields that tighten financial conditions are just what the economy needs for yields to decline.

Thus, high starting yields plus the potential for capital appreciation and portfolio diversification can create attractive opportunities in fixed income markets, in our view. Indeed, investors can seek to construct resilient portfolios, with robust yields and predictable flows, with a moderate amount of risk.