US Government Bond Market

The yield on US government bonds move in super cycles
1900 3%
1920 5%
1945 2.5%
1980 14%

We last passed a secular yield uptrend driven by growth and inflation in the 1960s and 70s in a bond bear market that endured for some 35 years.

For the past 20 years bond yields have been falling steadily.

1. This reflects growing confidence that inflation has been squeezed out of the world economy.

2. Rapidly developing credit derivatives markets have made it easier for lenders to spread their risk. The boom in structured finance, whereby lenders are parcelling out the loans in various collateralised obligations and investors are buying small pieces they see fit. It is diffusing the risk.

U.S. Treasuries fell, extending five weeks of losses, as more investors ruled out the likelihood the Federal Reserve will lower interest rates this year.

5.25% is below the average of the past 40 years.

The inversion of the yield curve is not a preliminary sign of an economic recession, but simply a reversible anomaly.

1. Global factors are have pushed bond yields too low.
Especially the purchase of dollar bonds by foreign central banks (Chinese).
Foreign central banks are diversifying their currencies and asset classes.
The flow of saving from overseas that has so far helped to finance the US current account deficit on attractive terms will now be diverted to finance demand growth in many of our overseas trading partners — and in this context, that may contribute to somewhat higher US real interest rates.

2. Domestic forces also matter.
1. US real rates are getting a lift from an evident pickup in second-quarter US growth, which we see tracking at about 3½% annualized.
2. And “term premiums” — the compensation for moving out the risk-free yield curve —seem to have risen slightly as uncertainty about the global economic and monetary policy outlook has increased. Rising term premiums would add slightly to financial restraint.
Likewise, swap spreads — the benchmark generic risk premium for high-quality borrowers — have widened by about 10 bp over the past few weeks, adding to funding costs for intermediaries and their clients


There is therefore a disturbing possibility of a big secular yield uptrend driven by growth and inflation.

The so-called steepening yield curve indicates investors are more optimistic about the U.S. longer-term economic outlook.

Historically, the 20-year Treasury bond yield has averaged approximately two percentage points above that of three-month Treasury bills

The combination of rising real rates and stronger growth is a mixed blessing for risky assets:

Courtesy of global growth, earnings are stronger than expected, but investors may be wary of paying more for them. In my view, the correction in equities is a healthy development, since it will remind investors of their risk.

A major surge in yields could present more of a headwind to US and global growth, especially if it significantly undermined asset prices. And if global central banks go too far in tightening, growth abroad might be threatened.

The real danger for investors lies in lingering upside risks to US inflation, partly from domestic causes, but also from incipient inflation abroad and from rising protectionist sentiment in the US.