Recent fundamental data on the U.S. economy is mostly supportive for long-term bonds, in our view. Inflation is down from 2022 levels, consumer balance sheets are growing more fragile, and U.S. budget growth appears likely to slow, while the Federal Reserve has indicated that interest rates are unlikely to rise further and that price stability will take precedence over growth considerations when it comes to cutting. All in all, we believe the emerging picture of slower growth with an anti-inflation central bank should be good for government securities with long-term maturities.
But markets have been marching to a different drummer, with yields on 30-year Treasuries rising sharply in September. While various theories have been put forward to explain the price move, we think the answer is a simple—and, in our view, temporary—lack of available risk appetite for longer government debt.
For individual investors who are saving for their children’s college or their own retirement, we believe today’s fixed income opportunities should serve as a compelling reminder of the power of a long-term time horizon.
The usual suspects
Before delving into our view of what is behind the recent price action, it’s worth dealing with some of the other theories we’ve heard.
Higher inflation is frequently cited, but that explanation is inconsistent with other market signals. The Fed’s preferred measure of medium-term inflation expectations has barely budged in September, with a trivial 10 basis point rise in the 5y5y inflation swap (a market-derived measure of annual expected inflation between 2028 and 2033). In addition, the market’s direct projection of inflation over 30 years—the yield differential between fixed-rate and inflation-adjusted government bonds—has likewise moved only a fraction of the overall change in yields. We think it’s hard to argue that markets are spooked by inflation while investors forego “easy money” from inflation-linked investments.
Another idea we hear floated is that default fears driven by rising U.S. debt levels are pushing investors out of longer bonds. But that view ignores both the strengthening dollar and still-high global stock prices. In addition, Japan’s experience, with debt-to-GDP ratios routinely twice that of the U.S., is a contemporaneous counterexample of low bond yields and high debt.
Bonds on both sides of Pacific ignore debt levels
Japan has a higher debt ratio and lower 30Y yield than the U.S.
Chart comparing debt-to-GDP ratios for the U.S. and Japan alongside 30yr bond yields for both countries since 2004. The chart shows that Japanese debt ratios have always been larger than the U.S. levels, while bond yields remain lower. The chart also shows that higher debt ratios have not been associated with higher bond yields on a consistent basis.
Source - RBC Wealth Management, International Monetary Fund, Bloomberg; debt-to-GDP values for 2024 are based on IMF projections and bond yields reflect 9/26/23 closing levels
The real culprit
We think the biggest driver of the shift higher in yields is simply the lack of available risk appetite among the investors who have historically been key buyers of the asset class.
The largest holders of Treasuries are the Fed and overseas institutions. The Fed is currently engaged in quantitative tightening, and thus intentionally allowing its Treasury holdings to decrease. China’s policy is less transparent, but the country’s demand for U.S. government bonds has traditionally been linked to its policy of buying dollars. Recent news reports indicate the Chinese government has switched to supporting the yuan, potentially leaving China a net seller of dollars, and likely Treasuries as well. Outside of China, currency-adjusted Treasury yields are far from compelling for Japanese investors.
Other so-called natural buyers of longer-maturity bonds, including pension funds and individual investors, have already made large moves into the asset class and are seeing marked-to-market drawdowns. Even investors who share our view on the strong long-term fundamentals supporting bonds may not have space left in their asset allocations to add here.
When there is a dislocation between market forces of supply and demand, we normally expect faster-moving leveraged investors like hedge funds to fill the void. We can think of several reasons why that may not be happening now.
First, the inverted yield curve means buying longer-maturity debt is expensive for these traders, because they pay more on borrowed funds than the bonds generate in income. That situation, known as negative carry, is abhorrent to most traders. Longer maturities are also volatile, and since institutional traders’ performance is often measured by volatility-adjusted returns, adding an asset with lower yields and higher volatility is a potential double hit. This is especially impactful on risk appetite as we approach Q4, when many institutional investors look to protect returns heading into the end of the year.
It is critically important, in our view, for investors to remember that these types of dislocations often end with a sharp reversal—either when the risk constraint clears, or when prices reach a point where the risk-reward is too compelling to ignore.
Fundamentals eventually drive valuation, in our experience, and we think bond fundamentals look strong.
The case for bonds
To start, the Fed appears to be winning the war on inflation. With inflation well below last year’s levels, we believe the central bank will maintain its resolve even if growth slows and unemployment rises. Central banks and their leaders, after all, are ultimately judged largely on their ability to achieve price stability, and we think that gives policymakers the institutional and personal incentives to sustain restrictive policy as long as necessary.
In terms of growth, the dynamism of the pandemic era is fading. As of this writing, the U.S. government is approaching a potential shutdown; even if the government remains open, we think expansionary changes in fiscal policy are highly improbable in the near term. Corporations are also unlikely to spend aggressively, as more and more companies need to refinance pandemic-era debt at today’s higher rates.
Consumer spending—the largest component of the U.S. economy—is also under pressure. A recent Fed report found that only the top 20 percent of households by income have any remaining pandemic savings. Lower-income households are thus facing larger credit card balances, more expensive debt servicing, higher gas prices, and the imminent resumption of student loan payments with little or no excess cushion.
That leaves the growth outlook dependent on employment. Labor markets have outpaced consensus expectations for some time, but there are initial signs of softening in both hard data and anecdotal reports. More generally, the increasingly narrow base of growth leaves markets susceptible to a potential bond-positive growth scare, in our view.
Finally, we think bond valuations are attractive both in absolute terms and relative to equities, a topic we discussed in detail in a recent article.
Is time on your side?
Institutions are forced to think about portfolio returns over artificially short time horizons—often as little as three months, and rarely more than a year. Individual investors, on the other hand, typically have only one or two key dates in mind, and these are often years or decades in the future. This gives the individual huge power to look for assets that are attractively priced over the medium term, even if the short-term outlook is hazy or negative. In our view, that describes today’s fixed income market in a nutshell.