The US Federal Reserve is expected to reduce its purchases of Treasury bonds from the current US$80 billion per month. Tapering will change the supply and demand dynamics. Photo: TNS
by Chris Iggo
by Chris Iggo

How US Federal Reserve’s tapering decision will reshape global bond markets

  • What happens to Treasury yields will signal how the environment is changing and what will happen to global interest rates, credit markets and more
  • If the Fed waits longer before it starts to taper its asset purchases, yields could quickly move lower
Every three months, my colleagues and I meet to discuss the outlook for the global economy and, more importantly, bond markets. The US Treasury market and what will happen to the benchmark 10-year yield is always at the centre of discussions.

Part of the process involves hearing the views of economists and strategists at leading investment banks. We did the most recent review in early September. The range of forecasts for the 10-year Treasury yield for the next three months was anywhere between 1 per cent and 2 per cent.

Apart from telling us that most forecasts are likely to be wrong, the exercise signals that there is great uncertainty out there. What happens to Treasury yields will not only signal how the environment is changing but what will happen to other global interest rates, credit markets, equities and currencies.
At times in recent weeks, it has looked as though a 1 per cent yield was more likely than 2 per cent. Yields peaked in March and fell sharply over the summer because of the spread of the Delta variant of Covid-19 and strong technical demand for government bonds. This was despite rising inflation in the US and elsewhere.

Since August, the market has consolidated, with 10-year yields in a 1.20 per cent to 1.40 per cent range. Many investors still believe yields should be higher given the strength of the recovery and higher inflation.

The US Federal Reserve is expected to reduce its purchases of Treasury bonds from the current US$80 billion per month. Tapering will change the supply and demand dynamics.

How the Fed’s balancing act on tapering risks is pleasing no one

If yields rise again, there could be an impact on corporate bonds as well. The yield difference between corporate bonds and Treasuries has been low, but higher yields on risk-free government bonds might reduce the attractiveness of those bonds issued by companies.

The impact could also extend to equity markets. Higher yields prompted a marked rotation from growth to value stocks in the first quarter this year, and a similar development might be seen if yields do head higher again.

I’m not sure that yield levels of 1.5 per cent or even 2 per cent are enough to derail the strong performance of the US and global equities.

However, higher yields would signal something less strong in the growth outlook and a modest tightening of financial conditions. Under such a scenario, it would be fair to say that the strongest returns from equity markets were behind us.

Yet, there might be a chance of seeing a 10-year US Treasury yield of 1 per cent. The August inflation data from the US supported the view that inflation is transitory. It is also clear that the year-on-year rate of economic growth in the US and other advanced economies has peaked.
Downside risks have emerged as companies continue to struggle with supply bottlenecks and labour shortages. The recent sharp rise in oil and natural gas prices pose a deflationary threat to global growth through their impact on household purchasing power. Recent problems in the Chinese credit markets are also a source of potential financial instability.

Any of these could be a threat to global investor sentiment, leading investors to reduce their exposure to risk before the end of the year. Even equity market bulls would concede that the US markets’ winning streak cannot go on indefinitely.

Underlying low market yields for government bonds is the fact that real yields are in negative territory. There are numerous theories as to why, including a long-term decline in potential economic growth, demographic trends in the West and elsewhere, and regulatory and policy factors that have increased the level of global savings relative to investment.
There is also a growing feeling that economic uncertainty could have an impact on the global cost of capital, for which the 10-year US benchmark yield is a proxy. The global recession, Covid-19 and the emergence of climate change risks have all added to uncertainty. This prompts more risk-averse behaviour and a tendency to increase precautionary savings.

If the Fed decides to wait longer before it starts to taper its asset purchases, yields could move lower quite quickly. After all, in Europe and Japan, central banks are showing no sign of stepping back from their own bond-buying programmes.

Yields should be rising, given the global recovery and higher inflation. Looser fiscal and tighter monetary policies ahead should also push long-term interest rates higher. For now, though, the market is not buying that scenario.

The pain trade for many investors in the last quarter of 2021 could again be a rally in global bonds. My own view is that 1 per cent is more likely than 2 per cent.

Chris Iggo is the chief investment officer for core investments with AXA Investment Managers