Symbolic US Treasury bond yields matter less than the impact of soaring debt levels
Nicholas Spiro says that the 3 per cent level on 10-year US Treasury bonds may have a certain psychological importance to investors, but is not out of the ordinary historically. What is out of the ordinary is global debt levels, especially as a result of Trump’s policies, and investors should prepare accordingly
Over the past several days, international investors have fixated on the 3 per cent level in the yield on 10-year US Treasury bonds, a crucial benchmark for financial markets, breached on Tuesday for the first time since early 2014.
The rise in the 10-year yield, which stood at 2 per cent as recently as last September, above the psychologically important 3 per cent mark comes at a critical time for markets. Not only are there worries about stronger inflationary pressures, fuelled by the recent surge in commodity prices, there are equally important concerns about a slowdown in the global economy, centred around Europe. If that were not enough, markets have become a lot more twitchy following a sudden eruption in volatility in early February.
A sharper increase in the 10-year yield would fan fears about inflation, causing investors to speculate that the Federal Reserve will raise interest rates aggressively. This could put more strain on stock markets already under pressure due to concerns about lofty valuations and signs that growth has peaked. Higher bond yields, moreover, are likely to drive up the dollar which, as I noted in an earlier column, is starting to reflect the divergence in monetary policies between the United States and Europe. A sustained rally in the US dollar would be a major headwind for emerging markets.
Still, despite the significant risks posed by a further rise in the 10-year Treasury yield, it would be wrong for investors to continue obsessing over its precise level.
Firstly, it is real yields, taking into account inflation, that provide a more accurate gauge of underlying financial conditions. The real 10-year Treasury yield remains comfortably below 1 per cent, half its level before the 2008 financial crisis. While it has risen markedly since 2016, it is still extremely low by historical standards.
Even the actual 10-year yield remains low (it stood at 4 per cent just before the financial crisis) and has fluctuated considerably over the past five years. Predictions of the end of a 30-year bull market in bonds have so far proved unfounded, with every spike in the 10-year yield followed by a decline. Bond investors themselves are sceptical about a disorderly sell-off, with more than half of the 56 analysts surveyed by Bloomberg anticipating that the 10-year yield will end 2018 within 25 basis points of 3 per cent.
Secondly, and more importantly, instead of scrutinising the level of the 10-year yield, investors should pay more attention to one of the reasons behind its recent rise: the sharp deterioration in the US fiscal position since Donald Trump was elected president. Massive tax cuts and spending increases will cause America’s budget deficit to surpass the US$1 trillion mark by 2020 – two years earlier than previously estimated – and if made permanent, as assumed by the US Congressional Budget Office, they will drive up the country’s government debt-to-GDP ratio to nearly 100 per cent by 2028, from 77 per cent today.
The surge in America’s public indebtedness is part of the huge increase in the world’s public and private debt pile which, according to figures published by the International Monetary Fund last week, is now bigger than at the height of the financial crisis, with the bulk of the debt held by the US, China and Japan.
While the relative “safe haven” status of US sovereign debt should help mitigate the upwards pressure on yields stemming from heavier issuance of government debt and the unwinding of the Fed’s quantitative easing programme, the bigger concern – which markets choose to ignore – is that excessive levels of public and private debt increase the scope for a much sharper economic downturn. Not only do countries that are too indebted lack the fiscal space to counter recessions, too much private debt can trigger “an abrupt deleveraging process and ultimately a financial crisis”, the IMF warns.
That these risks are not reflected in asset prices – in both developed and developing economies – is cause for concern. While the US bond market has at least begun to reprice – especially in the case of the two-year yield, which has shot up to its highest level since 2008 – many European and Japanese bonds are still trading in negative territory. Spreads, or the risk premium, on emerging market corporate debt, moreover, remain close to their historic lows.
A 3 per cent 10-year Treasury yield may be a milestone, but it should not overshadow other, more important, vulnerabilities in markets.
Nicholas Spiro is a partner at Lauressa Advisory