The 10Y Treasury yield has jumped nearly 130bp from its low point in early May. Given the tight ranges and low volatility of yields during the most of QE era, this kind of move in just over 3 months seemed stunning to some investors. Consequently, the question that has come up often recently is: what has been driving Treasury yields?
As UBS' Boris Rjavinski notes, several years ago a rate strategist would give you a straightforward and predictable answer: inflationary expectations, economic growth projections, and current and future monetary policy. The “monetary policy” part of the answer would likely simple deal with the path of the key short-term policy rate. Terms such as “quantitative easing”, “communication policy”, “thresholds and triggers” were foreign to bond investors during the era of pre-credit crisis innocence.
But now, as Rjavinksi notes, central banks and politics in the driver seat. Volatility will remain elevated as we await key messages from the Fed in September, and U.S. political calendar will start to heat up as we approach the “drop-dead” dates to fund the government and extent the dent ceiling.
Central banks and politics in the driver seat
The relative importance of these key Treasury yield drivers has flipped upside-down in the past couple of years, as central banks have assumed the key role. Through a host of unconventional monetary policy tools, such as zero interest rate regime, multiple rounds of QE purchases, new communication policy, and unprecedented transparency regarding future policy actions central banks have effectively crowded out the effects of economy and inflation. Having brought its short-rate benchmark to zero, the Fed has boldly moved out on the curve directly targeting longer maturity yields.
Politicians and policymakers have closely followed the Fed as the next important Treasury market driver. Fights over government borrowing limit, budget deficit, taxation policy, as well as pre-election sentiment swings and major political developments in the eurozone have affected government bond yields in a major way.
With central banks and political risk driving the bus, traditional factors have been pushed down to the bottom of our short list. Figure 1 below provides a good illustration of these developments, as it shows evolution of 10y Treasury yield relative to some of the key developments in the recent years.
Prior to mid-2008 the 10y yield and the UBS US Growth Surprise Index have tracked quite closely, generally trending in the same direction and matching each other’s turning points. However, it had drastically changed starting in late 2008. The first big divergence occurred when the QE1 asset purchase program was announced by the Fed. While the Growth Surprise index continued to drop for a while, Treasury yields had turned higher on expectations of higher future growth and inflation, thanks to the huge amount of monetary stimulus. The politics had also played a role, as the Obama administration rolled out a very large fiscal stimulus package.
Figure 1 shows that as the effects of the QE1 and the fiscal stimulus started to fade in 2010, the two lines began to converge again. 10y yield and the Growth Surprise index even managed to march upward together in the early stages of the QE2 in late 2010. However, the firepower of Fed’s balance sheet through ongoing QE2 bond purchases forced yields lower in the spring of 2011, even as the Growth Surprise index kept going up for a while. Rising stress in the eurozone related to Greece further strengthened bid for Treasuries.
U.S. politics had stepped into the spotlight during the sovereign debt ceiling extension mess in July-August 2011 (Figure 1). As U.S. lurched to possible default, 10y yield plunged 100bp in virtually one swoop. The escalating eurozone crisis added downward pressure on yields. Finally, the Operation Twist announcement by the Fed forced Treasury yields to the cycle lows. Curiously, while the one-two punch of politics and monetary accommodation kept yields at historically low levels throughout H2 2011, the Growth Surprise index had turned decidedly upward, as one can see in Figure 1. However, that mattered little for some time; the central bankers and politicians were in the driver’s seat.
“Taper Tantrum” – same rule in reverse
Figure 1 shows that the same rule can be applied in reverse to the recent massive selloff in Treasuries. The U.S. Growth Surprise index has been clearly trending down throughout summer 2013. At the same time, Treasury yields were taking its cue from the Fed’s “taper talk” in its march upward. Clearly, investors decided that the timing, size, and composition of the taper were the key to where yields should be, while treating mixed economic data as the second order effect.
Bond fund redemptions have added upward pressure on yields
Recent rush of redemptions from fixed income mutual funds and ETFs may also have played a key role in the big jump in yields. As yields went lower during the QE era, many investors dutifully followed Fed’s lead into fixed income products. These inflows have been spread out over the period of 2-3 years and therefore allowed the markets some time to digest them, although they clearly contributed to rise in Treasury process and narrowing corporate bond spreads. The record amount of recent redemptions from bond funds and ETFs coming in a short time span may have added fuel to the fire of the Treasury selloff, especially given lower liquidity in the summer months.
To illustrate that point, we estimated historical flows into and out of the three large popular fixed income ETFs: a core bond, an agency mortgage, and an EM bond funds. We then plot estimated flows against the 10y yield in Figure 2. One can clearly see that, as the period of relatively balanced flows throughout 2012-early 2013 gives way to the flood of redemptions starting in May, the Treasury yields begin to move sharply higher. A risk of large redemptions is something we have discussed in our publications earlier this year1. Figure 2 does seem to indicate that bond fund flows may need to become more balanced first for the Treasury yields to be able to settle in a range again.
Recent move is not outsized in historical context
While Chairman Bernanke and other FOMC members have been adamant that “tapering does not mean tightening”, the market seems to interpret it that way, at least thus far. Therefore, it is logical to compare the recent upward move in 10y yield to the similar moves during previous monetary tightening cycles. In 1994, the 10y went up about 180bp in the first 3 months after the initial hike in February. The reaction after the first hike in June 1999 was much more muted, but the 10y yield had already jumped about 80bp prior to the hike. The tightening cycle that started in June 2004 may be the most appropriate comparison, since rates were rising from historically low levels. There was an almost 120bp jump in 10y yield in about 3 months prior to the first policy rate increase (which was followed by about 80bp rally over the next 3 months). While the current volatility may seem excessive, it is not outsized in historical context.
Volatility is here to stay for some time
Given that central banks, politics, and the outsized fund flows continue to be the key drivers behind Treasury yield gyrations, everyone’s model will likely be challenged to come up with accurate directional calls. We believe the best course of action for Treasury investors in the current environment is to stay close to the benchmarks and keep risk low. Several large U.S. fixed income investors we met recently seemed to agree with us that right now is not the best time to take directional view on rates. However, we feel confident that volatility will remain elevated as we await key messages from the Fed in September, and U.S. political calendar will start to heat up as we approach the “drop-dead” dates to fund the government and extent the dent ceiling.
If we get more clarity from the Fed on the size, timing and composition of QE taper, and if key political issues get addressed later this fall, we may actually see economy and inflationary expectations start to return to their traditional role as the drivers of Treasury yields.