The 10Y Treasury yield has jumped nearly 130bp from its low point in early May. Given the tight ranges and low volatility of yields during the most of QE era, this kind of move in just over 3 months seemed stunning to some investors. Consequently, the question that has come up often recently is: what has been driving Treasury yields?
As UBS' Boris Rjavinski notes, several years ago a rate strategist would give you a straightforward and predictable answer: inflationary expectations, economic growth projections, and current and future monetary policy. The “monetary policy” part of the answer would likely simple deal with the path of the key short-term policy rate. Terms such as “quantitative easing”, “communication policy”, “thresholds and triggers” were foreign to bond investors during the era of pre-credit crisis innocence.
But now, as Rjavinksi notes, central banks and politics in the driver seat. Volatility will remain elevated as we await key messages from the Fed in September, and U.S. political calendar will start to heat up as we approach the “drop-dead” dates to fund the government and extent the dent ceiling.
Central banks and politics in the driver seat
The relative importance of these key Treasury yield drivers has flipped upside-down in the past couple of years, as central banks have assumed the key role. Through a host of unconventional monetary policy tools, such as zero interest rate regime, multiple rounds of QE purchases, new communication policy, and unprecedented transparency regarding future policy actions central banks have effectively crowded out the effects of economy and inflation. Having brought its short-rate benchmark to zero, the Fed has boldly moved out on the curve directly targeting longer maturity yields.
Politicians and policymakers have closely followed the Fed as the next important Treasury market driver. Fights over government borrowing limit, budget deficit, taxation policy, as well as pre-election sentiment swings and major political developments in the eurozone have affected government bond yields in a major way.
With central banks and political risk driving the bus, traditional factors have been pushed down to the bottom of our short list. Figure 1 below provides a good illustration of these developments, as it shows evolution of 10y Treasury yield relative to some of the key developments in the recent years.
Prior to mid-2008 the 10y yield and the UBS US Growth Surprise Index have tracked quite closely, generally trending in the same direction and matching each other’s turning points. However, it had drastically changed starting in late 2008. The first big divergence occurred when the QE1 asset purchase program was announced by the Fed. While the Growth Surprise index continued to drop for a while, Treasury yields had turned higher on expectations of higher future growth and inflation, thanks to the huge amount of monetary stimulus. The politics had also played a role, as the Obama administration rolled out a very large fiscal stimulus package.
Figure 1 shows that as the effects of the QE1 and the fiscal stimulus started to fade in 2010, the two lines began to converge again. 10y yield and the Growth Surprise index even managed to march upward together in the early stages of the QE2 in late 2010. However, the firepower of Fed’s balance sheet through ongoing QE2 bond purchases forced yields lower in the spring of 2011, even as the Growth Surprise index kept going up for a while. Rising stress in the eurozone related to Greece further strengthened bid for Treasuries....MORE