2023 Q3 In Review - Integrity Wealth Advisors, Ventura & Ojai, California

UNDERSTANDING THE RISE IN BOND YIELDS
2023
Q3
IN REVIEW
The incredible resilience of the U.S. economy,
highlighted by September’s payroll numbers, has
caused government bond yields to rise sharply.
Steepening of the yield curve creates a compelling
opportunity for investors in money markets to
consider adding longer-duration assets, in our
view. Starting yields are high relative to history
and to other asset classes on a risk-adjusted
basis. This can create a “yield cushion” amid a still
highly uncertain outlook. In addition, bonds have
the potential to earn capital gains and diversify
portfolios. Indeed, investors can now seek to
construct resilient portfolios, pursuing robust yields
and predictable flows, with a moderate amount of
risk.
The spike in rates is also working to tighten
financial conditions by making new debt much more
expensive. This should eventually raise the cost
of existing debt as fixed terms run out on loans to
businesses and households. Higher yields have
already contributed to stagnating flows of new
loans this year. We believe this may eventually slow
economic activity and moderate inflation enough for
central banks to ease.
Paradoxically, yields have jumped despite developed
market central banks having neared the end of their
respective hiking cycles, and as headline inflation
rates have moderated meaningfully. This has raised
questions about the underlying drivers of the recent
market repricing.
Consider that U.S. Treasury yields have risen and
the yield curve has steepened with real rates –
indicated by yields on Treasury Inflation-Protected
Securities (TIPS) – leading nominal bond yields
higher. By contrast, the spread between real and
nominal rates, or the breakeven inflation spread,
hasn’t changed much at all. This suggests that
investors aren’t worried about inflation risks, but are
nevertheless demanding a higher real term premium
to hold longer-maturity government bonds.
Why would investors all of a sudden demand more
real term premium? At the heart of it, we think
it relates to a combination of factors that have
recently shifted private investors’ outlook about
future government bond supply. Expectations of
greater supply have meant a higher yield required by
the marginal investor. These factors include:
1. More resilient economies and lower recession
risks. This suggests that central banks can
continue for longer to reduce their holdings
of government bonds. The process, known
as quantitative tightening or “QT,” tends to
boost the supply of bonds in the market and
tighten financial conditions. Earlier in the year,
the U.S. regional banking crisis led to a steep
drop in policy rate expectations and lower
term premiums embedded in longer-dated
bonds. Markets were pricing in the prospect
of recession and policy easing, including a
cessation of QT.
2. Resilience in developed economies outside
the U.S. Importantly, this has reignited enough
inflationary pressures in Japan for its central
bank to ease away from its yield curve control
policy. Over the past decade, the Bank of Japan
(BOJ) has been an important source of demand
for Japanese Government Bonds (JGBs). This
crowded out Japanese domestic investors from
their local bond markets, increasing demand
for global bonds. Now that the BOJ is easing
away from these policies, there should be more
JGBs for the private sector to buy to finance
Japanese government deficits – thus reducing
demand for Treasuries.
3. The outlook for the U.S. deficit has also been
ratcheted up. In particular, there have been
growing concerns over the future cost of
government tax credits and subsidies related
to green energy investments. In May, the
Congressional Budget Office (CBO) revised
higher its 10-year outlook for costs stemming
from last year’s Inflation Reduction Act – the
largest-ever investment into addressing climate
change. Private forecasters have asserted that
because these new government incentives
are uncapped, even the CBO’s latest estimates
may be grossly underappreciating longer-term
costs. That could require increased issuance of
Treasuries.
These factors have raised fresh questions
about U.S. debt sustainability. Government debt
loads have gotten more expensive to service
as interest costs rise amid moderating nominal
growth. Concerns about debt-sustainability were
exacerbated by Fitch’s downgrade of the U.S.’s
sovereign credit rating to AA+ from AAA in August.
However, the spread between Italian government
bonds and matched-maturity German bonds has
also widened in Europe as investors grapple with
debt-sustainability questions there.
INVESTMENT IMPLICATIONS
The normalization in the shape of the yield curve
and repricing of real yields reflects investors’
demand for higher yields in the face of greater
supply. However, what’s good for investors is
not necessarily sustainable for the economy
over the medium term. Higher rates have further
tightened financial conditions, which should weigh
on investment, real GDP growth, and eventually
inflation. In other words, higher yields that tighten
financial conditions are just what the economy
needs for yields to decline.
Thus, high starting yields plus the potential for
capital appreciation and portfolio diversification
can create attractive opportunities in fixed income
markets, in our view. Indeed, investors can seek to
construct resilient portfolios, with robust yields and
predictable flows, with a moderate amount of risk.
SOURCE: Pimco