The Global Assets "pricing anchor" is approaching the 5% red line, which may trigger a chain reaction! Will tonight's CPI data be an accelerator or a buffer?
Bond yields are rapidly rising almost everywhere in the world. The USA's CPI data at 21:30 tonight may determine whether the bond market's sell-off intensifies or hits the pause button.
The yield on the USA's ten-year treasury bonds is gradually approaching 5%. The yield on Germany's bonds is currently 2.6%, up from about 2% in December last year. Japan's bond yields are also climbing. The situation in the United Kingdom is particularly extreme, with British bond yields recently nearing 5%, the highest level since 2008.
Rising bond yields are bad news for governments, as their debt servicing costs will rise accordingly. This is also painful news for holders of various loans such as mortgages, auto loans, and credit card debts, as their bills ultimately depend on the government's borrowing costs. After all, the yield on ten-year US treasuries is considered the anchor for global asset pricing.
What's going on? Despite several developed countries' central banks having started rate cuts, the real economy has seen almost no relief. Borrowing costs for businesses and households have changed little. In the USA, the rate on 30-year fixed-rate mortgages is approaching 7%, which has actually increased by one percentage point over the past few months. In the Eurozone, even after central banks cut interest rates, the rates on new loans for businesses have only decreased by less than one percentage point. This situation is in stark contrast to before the COVID-19 pandemic when bond yields fell to historic lows.
Part of the reason is related to inflation. In an environment where consumer prices are rising rapidly, investors are demanding higher bond yields because they expect central banks to keep policy interest rates high for an extended period, and to compensate for inflation's erosion of purchasing power. Recent data suggests that the speed of declining inflation will be slower than previously anticipated.
In G10 countries, nominal wages are still growing at an annual rate of 4.5%. Considering sluggish productivity growth, this may be enough to keep inflation above central banks' targets. In the USA, the employment report released on January 10 shows that the labor market is far from slowing down. In the Eurozone, there are signs that wage growth is actually accelerating. In some countries, survey-based inflation expectations show an upward trend. Inflation data is also rising. The average inflation rate in G7 countries rose from 2.2% as of September to 2.6% as of November.
However, market pricing indicates that other factors are at play. With the exception of Japan, concerns about rising prices have not appeared in inflation-related financial derivatives. In the USA, UK, and Eurozone, such inflation expectations have seen a decline in recent weeks. Investors seem to believe that the inflation pressures facing the economy are larger than previously imagined, but at the same time, they think that central banks will be able and willing to control inflation through more hawkish monetary policies.
Investors expect greater uncertainty in the future. This may have increased the "term premium"—the extra yield of long-term government Bonds over short-term Bonds, beyond what can be explained by changes in central bank policy rates. The term premium provides compensation for Bonds holders to cope with the risks of significant declines in Bonds prices, such as if unexpectedly high inflation forces the central bank to raise interest rates sharply again. Since early December, the rise in the yield of the ten-year US government bond has been almost entirely due to the term premium.
It is easy to understand why uncertainty has spread. Will Trump expel millions of illegal immigrants after taking office? No one knows. But if he fulfills this promise, employers will lose a large number of workers, and inflation could soar. The situation is similar for tariffs, which will also lead to rising prices.
Investors also see uncertainty in the economic growth outlook, with the dominant narrative shifting from one extreme to another. However, there are optimists who believe that Trump’s proposed economic policies and reforms, including significant cost-cutting and tax reductions for tips and social insurance, will stimulate growth. Perhaps a productivity surge driven by AI is also on the way. All these conflicting factors further heighten the term premium for government Bonds.
Fiscal policy has not helped to address the problem. This year, G7 countries are expected to have an average fiscal deficit of 6% of GDP, which appears unusually high given the low unemployment rate and strong economic growth. These deficits mean that the government will need to issue new Bonds. The USA is expected to issue about $2 trillion this year (roughly 7% of GDP), while Eurozone countries will jointly issue about 500 billion euros (513 billion dollars, about 3% of GDP).
Such a large supply puts downward pressure on Bonds prices, forcing yields to rise, since yields are inversely related to Bonds prices. Many in the market are concerned that the USA's fiscal trajectory is unsustainable in the long term, believing that this fact will soon be brutally exposed, especially if Trump's tax cuts are implemented. The "resistance" of Bonds holders may also continue to push yields higher, and they are referred to as "Bonds market vigilantes."
Goldman Sachs research shows that for every one percentage point increase in the ratio of fiscal deficit to GDP, long-term yields will rise by about 20 basis points. In the USA, the supply of long-term government Bonds may increase more than what the deficit implies. Trump’s treasury secretary nominee Scott Bessenette proposed reducing borrowing through short-term securities while increasing borrowing through long-term Bonds.
Central banks are making it harder for profligate governments. In response to high inflation from 2021 to 2023, they have implemented quantitative tightening (QT) by reducing the size of balance sheets through Shareholding of government Bonds. As the central bank stops buying Bonds and in many cases even actively sells them, private investors must absorb more Bonds.
The Economist magazine in the United Kingdom estimates that due to quantitative tightening, the actual Bonds issuance in G7 countries this year will be double that of their official planned amount. The European Central Bank's quantitative tightening may counteract the efforts of national governments to reduce Bonds issuance by cutting fiscal deficits.
What will happen next? Everything is currently filled with uncertainty. In some countries, especially the United Kingdom, the yield may slightly decline. Part of the reason is that the pace of Algo tightening will slow down, and the country will soon reduce the amount of Bonds sold to the market. At the same time, in developed countries, concerns about the resurgence of inflation may prove to be unfounded.
However, the fundamental forces driving yields up are unlikely to disappear, as expansionary fiscal policies are timely, geopolitical tensions continue to escalate, and trade frictions may intensify.
Additionally, although the term premium has risen, it is far from previous levels. During the high inflation and rapid interest rate increases of the 1970s and 1980s, the actual value of Bond portfolios was severely impacted, and investors shunned government debt. Until the 2000s, the term premium was measured in whole percentage points, rather than the decimals seen today.
Imagine if investors misjudge the likelihood and extent of the central bank's interest rate cuts this year, and policymakers are forced to raise rates again. In that case, investors would have every reason to avoid sovereign Bonds. If that is the case, yields could have significant room to rise.
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