VGSH - The 'Surprise' Scenario Pushing Treasury Yields To 5%

2023-10-31 14:51:00 ET

Summary

• What's driving Treasury yields higher?
• What high bond yields say about fiscal and monetary policy?
• Strong US GDP impact on the bond market.

The U.S. 10-year Treasury has been hovering near the 5% level as investors weigh the impact of strong monetary policy and loose fiscal policy. Hafiz Noordin, Vice President, Director & Active Fixed Income Portfolio Manager, TD Asset Management, discusses the outlook for the bond markets.

Transcript

Greg Bonnell: The 10-year treasury yield hovering near the key level of 5% south of the border. Investors are digesting yet another strong economic report out of the States, this time GDP. So where could the bond market go from here after this recent dramatic rise in rates?

Joining us now to discuss, Hafiz Noordin, Vice President, Director, and Active Fixed Income Portfolio Manager at TD Asset Management. Great to have you back on the program.

Hafiz Noordin: It's great to be back.

Greg Bonnell: All right, so we have a lot to go through. We did get a pretty strong read on the US economy today. We have been living in the past a little while with this US 10-year bond yield that just keeps flirting with 5%. We put it all together, where are we?

Hafiz Noordin: Yeah. So like you said, it's been a big move from about 4% to around the 5% level of the US 10-year. Usually what causes bond yields to rise is you either have tight monetary policy, so rising interest rates from the central bank or you'd have a loose fiscal policy -- so large borrowing from the government, which would mean that rates have to go higher to fund that.

The surprise this year is we've had both. And so I think what was probably more expected this year was the tight monetary policy. We're getting the same story in terms of the data, like you said, of strong growth led by the US, inflation that is, although it's declining, it's still well above the 2% target.

And then you have tight labor markets. And that's causing wage growth to stay firm and fueling some concerns that it could feed into another round of inflation. But that's the part that was generally known. It's persisting for longer than what might have been expected. But what was a bit of a surprise this year is that looser fiscal policy at a time when, generally, you would actually expect fiscal policy to get a little tighter.

The deficit in the US, in particular, should have been lower than 5% of GDP. Instead, it surprised closer to 6% to 7% of GDP. So that's just a lot more money that needs to be borrowed in the market. That's been fueling this latest move, in particular.

Greg Bonnell: If we're talking about budget deficits, larger than expected spending, larger than expected out of Washington, is it time to start discussing bond vigilantes on these shores? I mean I know they showed up in Britain last year. Are they showing up in the States?

Hafiz Noordin: Yeah, I think to a certain extent. The marginal buyer of bonds has changed from what was there before. In the past, we were used to the central bank with its QE programs being a consistent buyer of bonds. We were used to US banks being consistent buyers and foreign sovereign wealth funds and foreign reserve managers from other countries generally being pretty consistent in the US bond market.

They're all stepping back for different reasons. We know there's quantitative tightening, US banks don't have as much deposits as they used to. And so with that, we're seeing more the private sector being the one to step in as the marginal buyer. And they're definitely more price sensitive.

So I wouldn't necessarily say we're in a period where it's complete vigilante mode. It's not like what we saw, say, in Greece or Italy, but definitely more price sensitivity. And therefore, more focus on this idea of what's a fair value of government bonds in the US given the fiscal outlook and given policy rates in the central banks have to stay higher for longer.

Greg Bonnell: Now, I come from a journalism background, so we love numbers like 5% or 4% because it's easy in terms of storytelling. Is there a significance in the real world, in the fixed income world, to a 10-year yield at 5% or higher?

Hafiz Noordin: There is actually merit to it because psychological levels actually make sense. Because at the end of the day, the market is just a bunch of humans, all of which have behavioral biases. And so the 5% level has stuck out. Again, it's a round number.

But the other piece to think about is that the market tends to look back at historical periods of when the US 10-year traded at 5%. And what you can point to is the 2006 to 2007 period before the Global Financial Crisis. The peak in the US 10-year at that part of the cycle was around 5% to 5.2%. So the market has repriced yields higher and is now thinking, okay, are we similar in terms of this cycle compared to 2006 to 2007?

You can make the argument that growth was very strong then as it is now. But it probably had a bit of higher potential growth in the global economy sense. You had a much stronger China, a much stronger Europe. And so you could see why rates were higher back then.

But on the flip side, you also had less government debt compared to what you have now. So it's kind of like you've got lower potential growth now but higher government debt and higher deficits. So I think those are sort of balancing themselves out to say that 5% might be fair for the near term.

But I think what we have to look forward then is, what happens when the labor market starts to crack a little bit? Where do rates go? And we still think there's more room cyclically for US yields to come down.

Greg Bonnell: The world continues to become a more dangerous place just in the past couple of weeks -- a massive geopolitical event in the conflict in the Middle East. You put that on top of what was already transpiring for quite a bit of time with Ukraine and Russia. There's a lot of risk out there. And then bonds, traditionally a haven play, could we see a haven play for bonds that might bring down yields in the next little while?

Hafiz Noordin: They should over the long run continue to provide that safe haven status in a portfolio. That hasn't worked for the last few months, for sure. Correlations with bonds and equities have gotten more positive, so bonds and equities are moving up or moving down together.

And largely, it goes back to the idea that there are concerns right now about funding these fiscal deficits and the large amount of issuance. So I think that's been skewing those correlations. So right now, we've seen the safe haven status be more evident in the US dollar and in gold.

I think those are two markets where we've seen that correlation be more negative relative to equities. But I think bigger picture, in a longer time frame, bond yields will continue to still be a major flight to quality asset, particularly US treasuries just because you generally still have a lot of foreign investors coming into the US market when they are trying to seek protection from their capital.

Greg Bonnell: Of course, you mentioned earlier about central banks got this ball rolling about a year and a half ago. We heard from our central bank yesterday. We're getting the Fed next week. I think we got the European Central Bank. So there's a lot going on in that space. What's intriguing to you? What's standing out for you?

Hafiz Noordin: Yeah. So I would glean from all of those that they're in the similar stage of, call it, a hawkish hold, right? So they've done a lot of tightening. They're seeing growth data staying strong but not necessarily running away. And they're seeing inflation coming down from the peaks and generally trending back to target but at a fairly slow pace.

So this idea that they want to pause, and be at these very restrictive rate levels, and see how it plays out, but also commit to keeping those rates higher for longer. That's the balance they're playing of not sounding too dovish by pausing, showing that they have commitment to getting inflation down. And that may mean that there's no rate cuts anytime soon. For the Fed and Bank of Canada, in particular, really looking to the second half of next year for when we could see rate cuts, if inflation does meet the targets that they're seeing for next year.

Original Post

For further details see: