Forces that affect the 10-year yield
To understand why the yield rose, it’s important to understand what forces
impact the 10-year yield. It is widely viewed that the three determinants
of the 10-year yield are growth expectations, inflation expectations, and
the term premium.
Simply put, term premium is defined as the excess yield that investors
require to commit to holding a long-term bond rather than holding a series
of shorter-term bonds. In a research note in 2007, the Federal Reserve Bank
of San Francisco explained that “a key component of the term premium is
investor expectations about the future course of short-term interest rates
over the lifetime of the long-term bond.”2 And that, of course,
is dependent on expectations about the economy in the future. That’s why a
rise in the 10-year yield versus shorter-term Treasuries is usually viewed
as positive, as it suggests investors are more optimistic about the future
of the economy.
But “term premium” is a catch all category dictated by supply and demand.
And supply and demand is impacted by central bank selling and new debt
issuance, as well as the fear trade and the yield trade, as I have
articulated in previous blogs.
The “fear trade”
Let me focus in on the fear trade. Typically, as investors have become
worried about macroeconomic and market conditions, their “safe haven” asset
of choice has increasingly become U.S. Treasuries. When demand for
Treasuries increases, yields go down, all else being equal. And last week
saw many developments that I believe should have caused worry among
* U.S.-China trade tensions increased, with China rewarding other trading
partners with lower tariffs as it worked to alienate the U.S. in their
dispute. In my view, this was a smart decision that showed China is playing
chess while the U.S. is playing checkers when it comes to trade.
* At a critical meeting of the 27 European Union (EU) member countries, UK
Prime Minister Theresa May’s Chequers plan (which outlined terms for the
UK’s post-Brexit relationship with the EU) was rejected. She is now coming
under increasing pressure from within the UK, and a no-deal Brexit seems
* Italy’s government must decide on a budget by September 27, but as I have
been saying, it must reconcile the competing interests of its coalition
government and the EU’s mandate for fiscal discipline.
And so it seems surprising that in a week of significant disruption and
macro worries, investors bought more risk assets and had less demand for
perceived safe haven assets such as Treasuries.
Concerns about inflation are rising
When I examine the recent rise in the 10-year yield, especially given other
recent developments such as the escalation in trade wars, I believe it can
be attributed to an increase in inflation expectations. And so, while
investors are celebrating stock market returns and a steepening of the
yield curve (which arguably suggests we are further away from a recession),
I am concerned because inflation caused by tariffs would not be a positive
development for any economy, let alone the U.S. economy, in my view.
From my perspective, market activity in the last week does seem to suggest
that investors are at least beginning to understand that trade wars may be
a likely reality – and that the U.S. may not come out on top. I believe
this understanding is reflected in the rise in the inflation expectations
component of the 10-year U.S. Treasury yield, the recent weakening of the
U.S. dollar, and the performance of Chinese stocks a couple of weeks ago.
The Shanghai Stock Exchange Composite Index rose more than 4% during the
week of Sept. 17 after being beaten down for much of 2018.3
Against a backdrop of simmering trade tensions, the U.S. Federal Reserve (Fed) this past week raised the fed funds rate to the 200-225 basis point range. In my view, recent developments are an important reminder of the importance
of maintaining an inflation-protection component in an investment
portfolio, given that inflation often rises when it’s not expected. There
are a variety of asset classes that may offer some level of inflation
protection, including inflation-protected securities, real estate,
commodities and gold.
1 Source: Bloomberg, L.P., as of Sept. 20, 2018.
2 Source: “What We Do and Don’t Know about the Term Premium,” the Federal
Reserve Bank of San Francisco, July 20, 2007.
3 Source: Bloomberg, L.P., as of Sept. 21, 2018.
is Global Market Strategist at Invesco. This article first appeared in
the Invesco blog.
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All investing involves risk, including risk of loss.
Diversification does not guarantee a profit or eliminate the risk of loss.
The S&P 500® Index is an unmanaged index considered representative of
the US stock market.
The CBOE Volatility Index® (VIX®) is a key measure of market expectations
of near-term volatility conveyed by S&P 500 stock index option prices.
The Shanghai Stock Exchange Composite Index is a capitalization-weighted
index that tracks the daily price performance of all A-shares and B-shares
listed on the Shanghai Stock Exchange.
Safe havens are investments that are expected to hold or increase their
value in volatile markets.
In a “no-deal” Brexit, the UK would leave the EU in March 2019 with no
formal agreement outlining the terms of their relationship.A basis point is
one hundredth of a percentage point.
The yield curve plots interest rates, at a set point in time, of bonds
having equal credit quality but differing maturity dates to project future
interest rate changes and economic activity.
The value of inflation-linked securities will fluctuate in response to
changes in real interest rates, generally decreasing when real interest
rates rise and increasing when real interest rates fall. Interest payments
on such securities generally vary up or down along with the rate of
inflation. Real interest rates represent nominal (or stated) interest rates
reduced by the expected impact of inflation.
Investments in real estate related instruments may be affected by economic,
legal, or environmental factors that affect property values, rents or
occupancies of real estate. Real estate companies, including REITs or
similar structures, tend to be small and mid-cap companies and their shares
may be more volatile and less liquid.
Commodities may subject an investor to greater volatility than traditional
securities such as stocks and bonds and can fluctuate significantly based
on weather, political, tax, and other regulatory and market developments.
Fluctuations in the price of gold and precious metals may affect the
profitability of companies in the gold and precious metals sector. Changes
in the political or economic conditions of countries where companies in the
gold and precious metals sector are located may have a direct effect on the
price of gold and precious metals.
The opinions referenced above are those of Kristina Hooper as of Sept. 24,
2018. These comments should not be construed as recommendations, but as an
illustration of broader themes. Forward-looking statements are not
guarantees of future results. They involve risks, uncertainties and
assumptions; there can be no assurance that actual results will not differ
materially from expectations.
© 2018 Invesco Ltd. All rights reserved. Used with permission.