Bond yields have been rising this year and volatility has well and truly returned. While a lot’s going to depend on Greece, if bond yields continue to rise, the size and speed of the upward adjustment could have a big impact on other asset classes.
While bond markets themselves are likely to keep providing good trading opportunities, they are also charts worth keeping an eye on. You can access our charts via the Treasuries section of the Next Generation platform’s product library.
Why yields are rising
The US 30-year bond yield recently peaked above 3.2% after hitting a low of 2.2% in late January. As I write this, however, investors have been in “flight to safety” mode with deadlines looming for the Greek debt crisis approaching. This has investors buying bonds and the US 30-year yield has retreated towards 3%.
So what determines long bond yields?
Theoretically, the yield investors require on a long dated bond is a function of funding costs (determined by the Fed rate in the case of US bonds); long term inflation expectations and credit risk. The US bond is traditionally regarded as free of credit risk so investors are looking to cover their funding costs and at least make up for the loss of value caused by inflation over time. It’s never all just about theory of course. Good old fashioned market sentiment is usually a factor and Central Bank buying has also of course been a major feature of world bond markets in recent years. Flight out of risky assets in times of trouble and into safe havens like US and Japanese bonds can also often be a factor.
In the big picture, this year’s rise in bond yields is about the market beginning to position for the Fed's monetary tightening. Although the Fed has not yet begun lifting rates, bond markets have not waited around for it to dot the ‘’'s and cross the’t’s. With the writing of higher rates on the wall and fears of deflation receding, bonds have been sold and yields have risen well in advance of the Fed’s first move. Assuming no major risk events, Fed tightening could also ultimately see other central banks gradually end QE policies and begin to lift rates.
Bonds not heading back to pre GFC levels
If this scenario pans out to be correct, it doesn’t mean that rates are on the way back to pre-GFC levels. Developed economies face a lot of headwinds and these seem likely to keep economic growth pegged at lower levels than before the GFC. These headwinds include:
• Poor balance sheets and a large debt repayment task
• Ageing populations in many cases
• The loss of manufacturing share to emerging economies
• The adjustment process of technological advancement which creates losers as well as winners
• Relatively poor economic government with politicians (and voters) unwilling to undertake a lot of the reform needed to maintain efficiency and competiveness in a rapidly changing world.
With economies looking unlikely to return to pre GFC growth levels, rates are also likely to stay lower. Former US Treasury Secretary and widely respected economist Larry Summers recently suggested, for example, that the coming Fed tightening cycle would see its rate peak at around 2.5%, with the next easing and QE cycle starting from around that level.
In this scenario, the Fed may well be very measured and cautious about how fast it lifts rates once the process gets underway. Unless inflation starts getting out of hand, it will not want either the US dollar or bond yields to rise too fast. If they do, it will exert too much negative pressure on a still fragile economic recovery.
Many think the Fed rate will still only be a modest 1.75% by the end of 2015. With the Fed Funds rate rising gently towards 2.5% and plenty of spare capacity in many world economies keeping inflation at relatively moderate levels; a peak in the US long bond yield in the range of 3.5%-3.75% might be a reasonable estimate for some time to come.
US T Bond – Cash chart
With all this in mind, the US T Bond chart together with the US T Note 10-year and Eurobond charts will be key markets to watch.
Bond charts are expressed in price rather than yield. Falling prices mean rising yields. Taking a look at the big picture monthly chart the 137 area appears to be a potentially significant level to watch for the long bond. This could pick up:
• Horizontal support and resistance dating back to 2010-2012
• The 38.2% Fibonacci retracement of the whole post GFC bond rally so far and
• The rising blue trend line (depending on how quickly price was to fall back to that level).
CMC Markets is an execution only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
Read all of our Q3 articles:Neutral outlook for sterling as UK growth evens offCooling China brings ANZ back to the pack Q3 market outlook: sector performance and earnings season preview European economy faces significant headwindsOvervaluation of stock markets and wishful thinkingWhat does the OPEC meeting mean for oil prices?Chinese equities: Will it all end in tears?The Japanese stock market could continue to rise in the coming monthsQ3 market outlook: a swing trading summer looming for US markets?