US Treasuries dance to different tune as fiscal policy takes precedence


A bruising start to the year for US government bonds has been accompanied by a striking shift in investor behaviour, with Treasuries becoming more sensitive to expected changes in fiscal rather than monetary policy.

Victories in key Senate run-offs last week sparked investor bets that the incoming Biden administration will inject another major stimulus into the world’s largest economy. That boosted growth and inflation expectations, knocking bonds. The sell-off drove the US 10-year yield, which serves as a benchmark for assets around the world, to a 10-month high above 1.17 per cent this week, from 0.91 per cent at the start of 2021.

The selling has continued in the face of the economic damage unleashed by the latest wave of the pandemic. Typically, such ultra-safe assets rally in times of economic strife as investors bet that central banks will respond with rate cuts or asset purchases. But on Friday, a disappointing US labour market report sparked a knee-jerk rise in Treasury yields.

“For many years, bond markets have followed a ‘bad news is good news’ mantra,” said Richard McGuire, head of rates strategy at Rabobank. “Now it looks like bad news for the economy is bad news for bonds too.” 

The focus on the prospects for a vaccine-supported recovery and higher inflation later in the year have numbed the market to poor economic data in the short term, said Guy LeBas, chief fixed-income strategist at Janney Capital Management.

Line chart of US 10-year break-even rate, %, showing market measure of inflation expectations climbs

“It’s interesting that there was no material buying of Treasuries on a disappointing payrolls release,” he said, adding that there was “material room” for rates to rise further due to the upward pressure on inflation. This is a particular concern for bond investors, given it erodes the value of the fixed interest payments Treasuries provide.

“I can’t recall a time since world war two when so many forces were aligned on the inflationary side,” said Mr LeBas.

The big question is how much fiscal stimulus will be added to the $900bn agreed by US lawmakers at the end of last year. The prospect for a further substantial spending boost brightened dramatically after the Democratic party won control of Congress following two crucial Senate races in Georgia last week, further fuelling a wave of optimism about fiscal stimulus that began with Joe Biden’s victory in November’s presidential election.

The president-elect has since suggested that a spending package could be worth “trillions” of dollars, spurring investors to shrug off the recent resurgence of Covid-19 which is already threatening to derail the global economic recovery.

Line chart of US 10-year Treasury yield, %, showing investors anticipate fresh injection of stimulus

“This additional stimulus means US growth expectations will probably be revised upwards for 2021, and also that supply of US Treasuries will be higher than anticipated,” said Felipe Villarroel, a portfolio manager at TwentyFour Asset Management. Both of those factors were likely to weigh on Treasury prices, driving up yields, he added.

He now expects 10-year notes to trade as high as 1.5 per cent by the end of the year, up from his initial forecast of 1.3 per cent. 

January’s rise in 10-year Treasury yields would be the biggest monthly increase in more than two years if it is sustained, Bloomberg data show. The move has ricocheted across global markets, pulling German yields to their highest level since September.

Longer-dated US government bonds have also been hit hard. Treasuries maturing in 30 years, for example, have had the worst start to a year since 2013, with yields more than 0.2 percentage points higher than at the end of 2020.

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According to Michael Feroli, chief US economist at JPMorgan, a further $900bn package passed in the next few months would boost US gross domestic product growth this year by roughly 1.5 percentage points to 5.3 per cent.

Inflation is set to rise substantially as well, with Mr Feroli expecting the Federal Reserve’s favourite inflation gauge — the core personal consumption expenditures price index — to edge closer to the US central bank’s longstanding 2 per cent target. It has languished below 1.6 per cent since April.

Market measures of inflation expectations have also drifted higher. The 10-year break-even rate, derived from prices of US inflation-protected government securities, now sits above 2 per cent for the first time since late 2018.

Bond markets’ resistance to short-term economic pain could be tested by further bad news on the spread of the virus, particularly if it punctures the recent equity rally. Treasury yields have pulled back slightly from their recent high, trading at 1.13 per cent on Wednesday, as the march higher in stock markets paused.

But for now, bond markets are “blind to the deterioration with respect to the virus,” said Mr McGuire. “Investors only have eyes for a vaccine-led recovery.”


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