Stephen Miller

The last few months have been characterised by high levels of volatility in the US bond market.

Longer tenor bond yields have risen sharply this year with the 10-year yield briefly rising above 5 per cent before retracing some of that move.

Some of that retracement reflects a view that the Fed has finished its hiking cycle. Given some positive inflation portents associated with wage and unit labour cost growth that looks a reasonable view. What remains highly contestable is whether the almost 100 bps of policy easing priced for 2024 is reasonable. There is a plausible scenario where that occurs, but it seems to me firmly at one side of the risk continuum.

I suspect that this is the view within the Fed and when the Fed Chair speaks tonight, he will be keen not to excite too much exuberance in bond markets that might undo the tightening in financial conditions to date.

There are also a number of good reasons why US bond yields may remain ‘high’ on a secular basis.

For one thing, the “neutral” interest rate appears to have risen from the abnormally low levels that applied post-Financial Crisis through to the end of the pandemic.

Certainly, the resilience of activity and the labour market during the current Fed tightening cycle is suggestive of the notion that the “natural” real growth rate has increased from that in the preceding 15 years or so, and that, accordingly, the “neutral” real interest rate should also have increased.

Other observers point to other emergent secular trends that might have pushed (and continue to push) the “neutral” real interest rate upwards: larger US budget deficits; investment demands on the savings pool from clean energy investments; and boomer retirees de-accumulating savings.

But what about inflation? That most of the increase in long tenor bond yields in the last couple of years is explained by an increase in real yields, suggests that the Fed has for the time being at least, successfully contained inflation pressures and expectations thereof by aggressively increasing the real policy rate.

But there are global structural currents that make elevated developed-country inflation rates more “sticky”. The globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating; globalisation of goods markets is in retreat as governments everywhere introduce protectionist measures under the guise of “industrial policy” and “national champions”; domestic regulation of markets is increasing in scope (leading to upward price pressures); and baby boomer workforce participation is declining (limiting labour supply and lifting wages).

That means to keep inflation, and more importantly inflation expectations, anchored central banks everywhere will need to maintain higher real policy rates and real bond yields need to stay “high”. If markets lose faith in the ability of central banks to adequately meet these challenges that might lead to higher inflation premia leading to higher 10-year bond yields. This is another reason the Fed remains particularly exercised to keep on top of inflation expectations through the “high for longer” mantra.

It is also a reason why the markets may be again getting ahead of themselves in pricing close to a 100 bps worth of policy rate cuts in 2024.

But just as there remain upside risks in the form of unanchored inflation expectations, or even higher real yields, they are arguably close to symmetric with downside risks associated with a sharper than anticipated slowdown and pronounced disinflation.

That there are downside risks to yields consistent with a lower inflation environment implies that bonds may reassume a role as a portfolio diversifier for “risky” assets.

And at currently prevailing yields therefore it is not a stretch to posit that bonds offer investors a modestly attractive yield without the prospect of significant capital losses.

It has been sometime since bonds were able to deliver these diversifying qualities to portfolios in the context of somewhat attractive yield levels. It is these diversifying qualities (along with reasonable yields) that are the most attractive element of bonds in a portfolio, not the prospect of significant capital gains.

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