More Than One Worry Is Hitting Bond Markets

logo-cropped-11Bond yields keep going up in response to higher inflation, lower global risk, and changing central-bank policies.

Source: The Wall Street Journal

There is a little bit of fear creeping into government bond markets. It is about time, even if investors are still underestimating how much long-term Treasury rates could rise from here.

Government bonds are no longer the can’t-lose market, as a steady drop in prices sends rates higher. The 10-year Treasury carries a yield of 1.79% versus the 1.36% it plumbed in early July in the aftermath of the Brexit shock. With global worries easing and central banks rethinking tactics and inflation picking up, yields could go higher still.

Fears that the world risked slipping into a deflationary spiral have eased. Higher oil prices have taken pressure off many energy-producing countries, and China’s efforts to stabilize its economy have had positive effects on other emerging markets.

Changes in central-bank policy also are playing a role. The Bank of Japan’s move last month to target the yield on 10-year bonds at 0%, with an aim to keep even longer-term rates in positive territory, reduced the relative attractiveness of Treasurys for Japanese investors. Expectations that the European Central Bank will alter its rules so it can buy more short-term, and fewer long-term, bonds are having a similar effect. Federal Reserve Bank of Boston President Eric Rosengren suggested over the weekend that the Federal Reserve replace long-term securities in its portfolio with short-term ones. The goal would be to tighten monetary policy by driving up long-term rates.

But perhaps biggest reason investors should worry about higher Treasury yields is an old one: inflation. The inflation expectations embedded in Treasury inflation-protected securities imply that inflation will average 1.52% over the next five years—more than 1.24% implied at the start of September, but still very low.

And probably too low. With oil no longer pulling prices lower, Barclays calculates that the inflation measure TIPS are priced off of will be running 2.4% by the end of the year. Seeing that sort of figure would force a lot of investors to rethink their view on rates.