US treasury bond yields plummeted to record-low levels last week.
The yield on the benchmark 10-year note fell to as low as 1.321% before rebounding fractionally in the wake of last Friday’s US non-farm payrolls report as concerns over the outlook for global growth and inflation encouraged buying from investors.
Even with the robust payrolls report, the 10-year note currently yields just 1.365%, well below the recent peak of 2.377% in early November last year.
It’s been a relentless, and monotonous, move lower, mirroring similar moves seen in European and Japanese sovereign debt markets.
Even with nominal yields trading at unprecedented lows, many expect the trend of the past few months to continue in the period ahead.
Like many other analysts, Francesco Garzarelli, Goldman Sachs’ co-head of global macro and markets research, has lowered his end of year target for US 10-year yields in response to the global collapse in sovereign bond yields, forecasting that they will finish the year with a yield of around 2%.
Yes, a downgrade to 2%, indicating that he expects US rates to move significantly higher — not lower — in the second half of the year.
“To many clients, this still looks like too a high number – an indication of where their ‘priors’ now are set,” says Garzarelli.
“The statistics we run suggest that US macro information has been pushing bond yields marginally up in recent months. These bond bearish domestic forces, however, have been completely overrun by global forces.”
“Those emanating from Japan have been particularly dominant,” he adds, suggesting that “the bond-bullish forces coming from Japan have been compounded by those from the UK.”
However, despite those factors, Garzarelli remains confident that domestic factors will likely lead to US yields reversing course over the second half of the year.
“The one area where our confidence remains high is on the trajectory of US inflation,” he says.
“If core services continue to run above 2% as our trend estimates suggest, headline CPI will rise from 1% currently to 2% by the end of this year.
“Moreover, the flight path for Fed Funds will be determined by the inflation outlook, as this is the area where the central bank is missing on its mandate,” he notes.
The chart below, supplied by Goldman’s, shows the acceleration in US services inflation over the past year.
Given his view that treasury yields are likely to rise strongly in the coming months, Garzarelli believes that recent correlations across asset classes will “shift”, leading to an increase in volatility.
Brexit is being interpreted as a local shock for growth, but as a global shock for discount rates, amplifying the ‘chase for income’ that was already in place before the vote,” he says.
“As bond yields increase from here, a shift in prevailing asset correlations and a pick-up in volatility is on the cards.”