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Over the last few weeks bond markets have been on the move.
30-year Treasury yields have rapidly surged from below 4% to almost 4.50% catching many by surprise.
But why?
And what drove this bond market action?
Thread.
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30-year Treasury yields have rapidly surged from below 4% to almost 4.50% catching many by surprise.
But why?
And what drove this bond market action?
Thread.
1/
Nominal bond yields can be thought of as the interaction between:
1️⃣ Growth expectations
2️⃣ Inflation expectations
3️⃣ Term premium
Let's explore what happened recently.
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1️⃣ Growth expectations
2️⃣ Inflation expectations
3️⃣ Term premium
Let's explore what happened recently.
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Growth expectations
When it comes to economic growth we must consider two angles: structural and cyclical growth.
Structural economic growth can be generated through more people joining the labor force and/or through a more productive use of labor and capital.
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When it comes to economic growth we must consider two angles: structural and cyclical growth.
Structural economic growth can be generated through more people joining the labor force and/or through a more productive use of labor and capital.
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The ability of an economy to generate structural growth is an important driver for long-dated bond yields (strong structural growth = structurally higher long-dated yields and vice versa)
Short-term economic cycles also matter for bond yields - particularly at the short-end.
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Short-term economic cycles also matter for bond yields - particularly at the short-end.
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Cyclical growth trends are driven by the credit cycle, the fiscal stance, earnings growth, labor market trends and more - the healthier they are, the higher short-end bond yields can be pushed.
What happened to growth expectations recently?
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What happened to growth expectations recently?
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Analysts stopped revising down their 2023 earnings per share (EPS) expectations and started revising them higher for 2024 - they are now looking for a healthy 12% EPS growth for next year!
On top of this, consider the AI-related discussions about higher productivity and...
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On top of this, consider the AI-related discussions about higher productivity and...
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...the stubborness of the US economy which refuses to slow down hard despite higher rates.
Both short-term (2024 EPS) and long-term (e.g. AI) growth expectations were revised higher: the first item of the equation above contribute to pushing 30-year Treasury yields higher.
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Both short-term (2024 EPS) and long-term (e.g. AI) growth expectations were revised higher: the first item of the equation above contribute to pushing 30-year Treasury yields higher.
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Inflation (Expectations)
The second component driving nominal bond yields is inflation: but NOT TODAY'S inflation - instead we are referring to long-term inflation expectations.
So, what happened there?
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The second component driving nominal bond yields is inflation: but NOT TODAY'S inflation - instead we are referring to long-term inflation expectations.
So, what happened there?
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Contrary to popular belief, investors are not scared of sticky persistent inflation: the US 5y5y inflation break-even has traded in a 2.45-2.75% range for the last 12 months.
That means investors expect US CPI inflation to float around these levels between 2028 and 2033.
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That means investors expect US CPI inflation to float around these levels between 2028 and 2033.
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In short, investors have pushed 30-year Treasury yields higher NOT because of fear over sticky persistent inflation but because of:
1) Positive re-rating of cyclical (EPS expectations pushed higher) and structural (e.g. AI) growth
2) Wait for it…
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1) Positive re-rating of cyclical (EPS expectations pushed higher) and structural (e.g. AI) growth
2) Wait for it…
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Term Premium
An investor looking to get fixed income exposure can do that via buying 3-month T-Bills and rolling them each time they mature for the next 10 years.
Alternatively, it can decide to purchase 10-year Treasuries today.
What's the difference?
Interest rate risk!
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An investor looking to get fixed income exposure can do that via buying 3-month T-Bills and rolling them each time they mature for the next 10 years.
Alternatively, it can decide to purchase 10-year Treasuries today.
What's the difference?
Interest rate risk!
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Buying a 10-year bond today rather than rolling T-Bills for the next 10 years exposes investors to risks – term premium compensates for this risk.
The lower the uncertainty about growth and inflation down the road, the lower the term premium and vice versa.
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The lower the uncertainty about growth and inflation down the road, the lower the term premium and vice versa.
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The chart above proves the point: the higher the uncertainty (x-axis moving to the right) about future growth & inflation, the higher the term premium (y-axis moving upwards)
Per our simple equation shown earlier, a higher term premium pushes long-dated bond yields higher
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Per our simple equation shown earlier, a higher term premium pushes long-dated bond yields higher
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So, what happened to term premium?
Estimates of the US Term Premium have moved higher and they are now testing the upper side of recent ranges: in other words, there is some more uncertainty being priced in about the path ahead for growth and inflation.
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Estimates of the US Term Premium have moved higher and they are now testing the upper side of recent ranges: in other words, there is some more uncertainty being priced in about the path ahead for growth and inflation.
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Investors are less confident about a future of predictably contained inflation and growth, and they expect some more volatility and uncertainty down the road.
Taking a step back though, term premium remains depressed by historical standards.
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Taking a step back though, term premium remains depressed by historical standards.
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The recent aggressive move higher in 30y Treasury yields is NOT driven by fears of persistently higher inflation but instead by:
1) A positive re-rating of growth
2) Slightly higher term premium, reflecting investors’ expectation for more unpredictable macro cycles ahead
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1) A positive re-rating of growth
2) Slightly higher term premium, reflecting investors’ expectation for more unpredictable macro cycles ahead
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The bond market scares away people with his jargon and technicalities, but understanding it is a key skill for macro investors
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17/17
I regularly publish insights & educational material on the bond market and macro at large on my newsletter
Consider subscribing: it's FREE!
👇
17/17
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