We love bonds, but we hate when they make the headlines. Let’s face it, while they are intellectually fascinating, there is no good news about bond markets. It’s always “someone is being replaced”, “someone is ruining the economy” or some other such abomination.
Readers would be hard-pressed to miss the excellent coverage that rising bond yields have created over the past few months. Or indeed front page news that gilts have generated through the last 24 hours.
There is an excellent explanation of what the current illness means for the government — and for UK citizens more generally — on MainFT.
But we think it’s worth giving up on a simpler geek question: What happened to bonds over the past few months?
step back most of the time the best answer to the question ‘why did gilt yields increase/decrease?’ is the ‘treasury market’.
While gilts do not move basis point for basis point with Treasuries — and the possibility of divergence is always present — the 10-year gilt and 10-year Treasury have tended to move together over the medium term. And Bunds tended to keep pace with US government debt until the Eurozone crisis put a wrench in European growth.
After the EU referendum, gilts were in limbo for several years, undecided whether to join Bunds in reducing economic stagnation or Treasuries in reducing reflation. After Liz Truss’ mini-budget shock in autumn 2022, they returned to trading mostly in line with government bonds.
The global rise in yields since mid-September may look unremarkable on such a long-term chart. However, the sale is still interesting and important. First, because of the nature of the sale. Second, because of the implications it has on other markets, as well as on state finances.
The ‘nature of the sale’? Does it get FTAV’concepts‘? Is there really anything more to say than “The line goes up, sad monkey“?
Yes, actually.
The recent low for gilt and US Treasury yields was on September 16, 2024 — two days before the Federal Reserve cut rates by 0.5 percentage points to 4.75-5.0 percent and three days before the Bank of England kept exchange rates stable to 5 percent. Both Fed and BoE since then they have reduced rates by 0.25 percentage points (November 7).
From that roughly low yield, 10-year Treasury yields rose 1.08 percentage points, and 10-year gilt yields rose 1.02 percentage points – to 4.7 percent and 4.8 percent, respectively, increasing the annual cost of each newly issued debt, and pushing the value of existing bonds.
We know that nominal bond yields and their changes can be divided into long-term inflation expectations (so-called break-even inflation rates) and real yields (that is, the amount promised to you after accounting for inflation). How much of the increase in yields is due to an increase in inflationary expectations? Some. But for the most part, the increase in bond yields is due to an increase in real yields.
There’s no shortage of theories about why inflation-linked bond yields should trade where they do, although we’ve yet to come across any that could be falsified. They can done considered exchangeable r-star financial markets — the market’s best guess about the medium-term equilibrium real rate for the economy as a whole. Although some people think the r-star is a bunch of crap.
Real yields on gilts have typically been lower than U.S. Treasuries over the past decade. Looking at the whole tradable r-star theory, you could be forgiven for thinking that this gap reflected market expectations for a lower economic growth trend. And, honestly, who knows? But a common belief among UK investors is that yields on inflation-linked gilts are lower than you might otherwise expect because UK private sector defined benefit pension schemes tend to have inflation-linked liabilities — and the sheer size of these buyers looking to protect their risk lowers binder yields to lower levels.
Here’s how real yields have developed over the past few years:
With nominal bond yields roughly translating into expectations for average central bank interest rates over a given time horizon, real yields reduced by structural pension demand will be matched by higher break-even inflation rates. And this is one explanation for demolition of the mandate the level of the rate of inflation which has been common to the UK market for most of the last fifteen years.
Today, the level of inflation that would be equivalent to the total return of a 10-year inflation-linked UK 10-year conventional (non-inflation-linked) gilt is around 3.6 per cent per annum. This is massive inflation. However, it is not drastically different from the 3.3 percent annual inflation rate that has been valued on average in the market over the last decade.
Breakeven rates and real yields aren’t the only way we can slice bond yield changes. As we found out in bond training campyields also share market expectations of overnight interest rate swaps (the average interest rate the market expects) and asset swaps (the amount governments must pay to rent private sector balance sheets, known as forward premiums).
Most of the rise in 10-year bond yields over recent months has been attributed to the market’s change in the course of the corresponding central bank interest rates over the next decade. And this super chart made from data provided by Goldman Sachs’ Christian Mueller-Glissmann shows the extent to which longer-term bond yields have moved with expectations for very short-term Fed rate action. In September, options markets were pricing in a sixty percent chance of eight or more cuts over the next twelve months. Now the price is a 30 percent chance of one or more hiking for the year.
But on this side of the pond, gilt yields rose a bit more than could be explained by expected moves by the Bank of England alone. Lawrence Mutkin, head of rates strategy EMEA at BMO, highlights this notion of a premium as something that is increasingly becoming a big deal for bond markets around the world. As he puts it:
when the Thermal Premium increases for the state, the Thermal Premium for all others will also increase. This is what “squeezing out” looks like.
How might central banks respond to rising term premiums? Maybe by lowering rates? If so, that – Mutkin claims – is fiscal domination at work. 😬
How does this concept of premium develop? not good Although gilts have depreciated quite a bit relative to swaps over recent months, this only brings them to the levels already achieved by US Treasuries relative to their swap curve. Is it the result of QT / excessive government issuance? Please answer in the comments.
Now we realize that we have thrown you a lot of cards. And while it’s usually not a done deal, we really don’t see why we shouldn’t throw these various slices and dice into one holistic graphical overview to show not only what happened to 10-year bond yields, but other tenors as well.
So while the answer to the question “how much have bond yields risen since mid-September?” is “close to one percentage point for bonds with five to thirty years to maturity in both the treasury and gold markets,” the reasons for these moves are varied:
In both markets, the simple reason bond yields are higher is that the markets expect the Federal Reserve and the Bank of England to have higher interest rates not just in the next year, but in the next five, ten, even thirty years than they have. in mid-September.
At the same time, measures of inflation expectations in the bond market did not jump, but this could also be because markets expect the Federal Reserve and the Bank of England to have higher interest rates than they did in mid-September.
In the UK, gilts have become cheaper relative to swaps, with 10-year gilt premiums rising rapidly towards levels seen in the US government bond market.
None of this really helps you understand the intraday moves in bond markets that happened yesterday — variously interpreted as investment banks’ sloppiness in managing exchange rate locks, to the results of a soft five-year gilt auction, to bond vigilantes testing the Chancellor’s mettle. But hopefully it provides some useful context.
Further reading:
— Sterling’s sell-off will continue until morale improves
— Everything You Always Wanted to Know About Bonds (But Were Afraid to Ask)
