Why did the yield on US debt break 1.5%?

Us bond yields rose sharply. Us bond yields have shown an upward trend since August 2020, especially recently at a much faster pace. Us bond yields exceeded 1.0% in early January and 1.5% on Feb. 25, rising 50BP in less than a month, causing market shock.

There are differences in the drivers of this upward wave. Generally speaking, the yield on US bonds is the nominal interest rate, and the nominal interest rate is equal to the sum of real interest rates and inflation expectations. As a result, the rise in general nominal interest rates is driven either by higher real interest rates or by higher inflation expectations.

Before February this year, the rise in US bond yields was mainly driven by inflation expectations. from August last year to January this year, US bond yields rose 55 BP, with real interest rates basically unchanged. The rise in US bond yields was all driven by inflation expectations, which rose to 2.13%, an 18-year high.

Behind it is the expectation of economic recovery. On the one hand, a new round of US $1.9 trillion fiscal stimulus is about to fall to the ground; on the other hand, with the continuous acceleration of vaccination, the epidemic in the United States is constantly improving. In addition, the rising price of crude oil, driven by a low base and a gap between supply and demand, has helped to boost inflation expectations.

The February upswing was mainly driven by rising real interest rates. Treasury yields overall rose 35 BP in February, while inflation expectations rose only 4BP and real interest rates rose 31 BP. It can be said that this wave of rising US bond yields has been driven entirely by real interest rates.

Historically, the rise in real interest rates in the past decade is generally related to the Fed's rate hikes, only in May of 13 years and March of 20 years in the non-rate hike cycle. Among them, March last year was related to the liquidity crisis, and May 13 was related to the Fed's signal of "tapering QE", which reflected changes in bond supply and demand. At present, the rise in real interest rates may be related to changes in the structure of supply and demand.

On the one hand, the structure of US bondholders has changed greatly.

Foreign investors' holdings of US debt peaked at the end of 14 years and have since gradually declined, in response to the Fed's shrinking QE, essentially due to a decline in demand for US debt. Demand from foreign investors for u.s. debt is still falling, with holdings falling to 25.5% as of January, the lowest level since 2007. At the same time, under the impact of liquidity and the epidemic, in order to stabilize financial markets and provide effective support for the smooth implementation of fiscal stimulus, the Fed has had to increase its bond purchases since September 1919. As of January this year, the proportion of US debt held by the Fed has risen to 17.2%, a record high.

Further, so far, total US debt has reached nearly $28 trillion, an increase of $5.2 trillion from September 19, of which 53 per cent was bought by the Federal Reserve.

On the other hand, the supply of US debt is still expanding.

Affected by the COVID-19 epidemic, the United States has implemented several rounds of financial rescue programs, and the fiscal deficit has expanded rapidly. by the end of 20 years, the fiscal deficit exceeded 3 trillion US dollars, a record high. The new round of US $1.9 trillion fiscal stimulus has already passed the House of Representatives vote; in addition, Biden put forward a $1.5 trillion-2 trillion infrastructure investment plan during the campaign, so the US fiscal demand for debt in 21 years may be about $4 trillion. Will continue to increase the issuance of treasury bonds. However, at present, the Federal Reserve still maintains the pace of bond purchases of $120 billion a month, which is difficult to meet the US supply, and the gap between supply and demand will not widen greatly, which will further boost US bond yields.

For example, the auction multiple for three-year Treasuries fell to 2.02 on February 9, the lowest since 2009, and the auction rate for seven-year Treasuries fell to 1.86 on February 25, the lowest level since 2008, suggesting that the gap between supply and demand for Treasuries is indeed widening.

In addition, apart from the macro level, the trading behavior at the micro level also has a certain impact on the recent acceleration of US bond yields. The exemption from the Fed's SLR regulatory restrictions, for example, expires at the end of March, limiting the ability of banks or primary dealers to take on Treasuries. The convexity hedging of the MBS market simply means that if interest rates rise and the duration of MBS holders will increase, then they will choose to sell long-term treasury bonds to offset this effect; once interest rates continue to rise, it will cause a chain reaction and lead to a new round of treasury bond selling.

What is the impact of rising interest rates?

Treasury yields may continue to rise.

On the one hand, driven by economic recovery and crude oil prices, US inflation in the second quarter may exceed the Fed's 2 per cent inflation target. According to data released by the US Department of Labor, the highest residence weight in the US CPI composition is more than 40 per cent, followed by food and beverage and transportation, with weights of about 15 per cent. Among them, the energy weight is about 6%, although the energy weight is relatively low, but due to the volatility of crude oil, the trend of US CPI and energy CPI is more consistent. At present, although production has recovered somewhat, it has not returned to normal, and the demand for crude oil is relatively strong. Under the production reduction agreement, the gap between supply and demand is still large, superimposed by the low base effect, and the growth rate of crude oil will increase significantly in the second quarter of this year.

On the other hand, with the gap between supply and demand of bonds widening, it will be difficult to narrow the gap if the Fed does not change its bond purchase program. So, taken together, US bond yields as a whole will continue to rise, so what will be the impact?

Gold will come under heavy pressure.

From the historical trend, there is a relatively consistent negative correlation between the gold price and the real rate of return, which reflects the gold holding cost. Once real yields continue to rise, the cost of holding gold rises relatively, and investment demand falls, gold will begin to fall. The last round of gold price decline was also due to the release of a signal from the Federal Reserve to reduce "QE". Us bond yields rose sharply and gold began a downward cycle.

U. S. stock overvalued sectors will also be under pressure.

The rise in real interest rates means that the financing costs of enterprises are rising, and the sectors with high valuations will be under greater pressure. From the historical trend, there is an obvious negative correlation between the dynamic valuation of the S & P 500 and the real rate of return. From the relative performance of S & P 500 value stocks and growth stocks in recent years, it is also closely related to the real rate of return.

What can the Fed do?

So what can the Fed do about the continued rise in US bond yields? Looking back at history, there are two main types of measures that the Fed can take now, one is the distorting operation (OT), and the other is yield curve control (YCC).

What is a twist operation?The distortion operation means that the Fed can buy long-term treasury bonds and sell short-term treasury bonds through open market operations, so as to change the term structure of its treasury bonds and extend the overall maturity of treasury bonds.

What are the benefits of twisting? First, it will help to hold down interest rates on long-term treasury bonds, reduce the financing costs of the real economy, stimulate economic growth, and reduce the burden of fiscal deficits. second, by taking this measure, the Fed can keep its existing balance sheet stable and the Fed can continue to maintain its current easing pace.

What is the actual effect of "twist operation"?

Looking back, the Fed has taken a total of two "distortions", the first in 1961, to promote capital inflows and the consolidation of the dollar, while avoiding the outflow of gold from the US government The second and most recent operation was in 2011, when at the FOMC meeting in September of that year, the Fed decided to buy $400 billion of 6-to 30-year Treasuries from September to June of the following year, and to sell the same amount of Treasuries with a remaining maturity of three years or less. The main purpose is to hold down long-term interest rates, maintain a broader loose environment and support a strong economic recovery. In addition, in June 2012, the Fed announced that it would extend its "distortion operation" until the end of the year, buying about $267 billion of 6-to 30-year Treasuries and selling the same amount of short-term bonds.

Since the "distorted operation" was announced in September 2011, the average real interest rate on US long-term treasury bonds has fallen by 77 BP, of which, the real yield of 7-year Treasury bonds has fallen by 65 BP,10 years, the real yield of 74 BP,20-year bonds has fallen by 57 BP, and the real yield of 30-year bonds has also fallen by 66 BP.

What is yield curve control?Yield curve control means that the central bank controls some of the long-end interest rates within the target range by buying and selling treasury bonds. In general, this is another tool that the Fed can use when short-end interest rates fall to zero is still not enough.

The difference between yield curve control and QE is that although both are achieved by buying bonds, QE mainly focuses on the number of government bonds purchased, while yield curve control focuses on the price of bonds. And only from the perspective of regulating the long-end interest rate, the regulation effect of yield curve control may be better. Because if the market believes that the central bank's commitment to control yields is credible, then market traders dare not trade against the central bank's target, causing the target to become the market price.

In September 2016, for example, the BoJ promised to fix the yield on 10-year Treasuries at around 0 per cent to push up persistently low inflation. After the implementation of yield curve control, government bond yields fluctuated around 9 per cent, and the number of government bond purchases continued to decline, from 119 trillion yen in 2016 to 71 trillion in 2019.

In addition, Australia is also implementing YCC. In March 2020, the Reserve Bank of Australia announced the adoption of YCC in response to the coronavirus and set the yield on three-year government bonds at 0.25%.

The United States used to control the yield curve during World War II. In 1941, the Federal Reserve and the Treasury discussed the rising debt problem and finally reached an agreement to set the yield on long-term Treasuries at 2.5% and that on short-term bonds at 0.375%.

As a result, the market equilibrium interest rate did not reach the upper limit set by the long-term interest rate between 1942 and 1947, so the Fed did not take any market action. Between 1948 and 1951, the Fed began to buy long-term government bonds when the long-term interest rate ceiling was under pressure; but when the Korean War broke out in 1950, the differences between the Fed and the Treasury deepened, and the Treasury wanted to keep interest rates low to finance the war. The Fed wanted to raise interest rates to cope with high inflation, and finally the tool was terminated in March 1951, with a long-term yield of 2.47%.

How do large categories of assets perform during distortions or yield curve control?

During the last round of "distorting operations", the dollar strengthened, US bond yields fell and US stocks outperformed crude oil and precious metals. Specifically, nominal yields on 10-year Treasuries fell 37 BP, while the dollar index rose about 7.0%. All three major indexes of US stocks rose sharply, with the Dow Jones Industrial average up 14.0%, the NASDAQ and the S & P 500 up 18.6% and 18.4%. Both crude oil and precious metals fell, with Brent crude down 6.4 per cent, London gold down 8.6 per cent and LME copper down 13.0 per cent, with London silver falling the most by 27.8 per cent.

During the period when the yield curve was under control, U. S. stocks performed equally well. According to existing data, between 1941 and 1953, long-term Treasury yields rose by more than 40 BP, mainly related to the war. Us stocks also rose sharply, with the Dow Jones industrial average and the s & p 500 up 150.9% and 169.4%, respectively.

How are the sectors of US stocks performing during the distorting operation?

On closer inspection, we found that during the distortion operation, value stocks in the US stock sector outperformed growth stocks, with the S & P 500 up 20.4%, while growth stocks rose only 16.8%. In terms of specific industries, the non-essential consumer and financial sectors outperformed other industries, with non-essential consumer stocks rising 28.7% and financial stocks up 16.0%. Health care, real estate, industry, information technology, communications equipment and other industries also performed well, with an increase of about 20%. The worst performers were utilities, energy and materials, with an increase of less than 10%.

Risk tips: vaccine progress is not as expected, Sino-US trade friction, epidemic situation, policy change.