Inflation risk continues for bond yields

Short-term interest rates are going down – the only questions are how much central banks cut, and how fast. Longer-term rates are another matter. Yields on US ten-year Treasuries are up by half a percentage point to 4.2% over the past month and UK ten-year gilts are up by a quarter point at the same level. That’s unusual: the only time in recent history that ten-year Treasuries have risen by that much immediately after the US Federal Reserve began cutting was during the 1995 soft landing.

Markets clearly do not believe we will return to the ultra-low rates of the past decade. This seems reasonable. Since 1962, the average (median) yield on the ten-year Treasury has been 5.6% and average inflation over the same period has been 3.09%. As a crude estimate of the real (inflation-adjusted) yields that investors might have been expecting (not what they got, which requires hindsight), the average difference between the two at each point was 2%.

If you figure that inflation will match the Fed’s target of 2%, then a 4.2% yield will give you an after-inflation return in line with the long-term average. If we consider inflation and yields only since 1990, when they’ve been consistently lower than in the 1970s and 1980s, the median difference was about 1.5%. The gap for the UK has been a bit higher: over 3% since the 1960s, but 2% since 1990. So overall bonds look priced for roughly fair value, if that’s the outcome we get.

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Time to worry about structural deficits?

Whether inflation will run at 2% is the big question. If it’s significantly higher, we’d expect investors to demand higher real yields (not just higher nominal yields). If it’s lower, we’d expect the opposite. We mentioned reasons why inflation could settle higher without being out of control, from fiscal policy to global trade to geopolitics. The latter is unpredictable, but the former seems clear.

The US runs a large deficit and that won’t change regardless of who wins the election. The UK is also heading in a direction of higher public spending. This is one plausible explanation for why yields are ticking up despite rate cuts: investors are worried about structurally larger deficits and higher inflation. In theory, long-term interest rates should be higher than short-term rates to reflect the risks that an investor takes in lending money for a longer period, so it may seem odd that ten-year yields are fairly close to both five-year yields (US: 4.05%, UK: 4.04%) and 30-year yields (US: 4.52%, UK 4.75%).

In practice, the typical term premium for holding longer-term bonds has been surprisingly modest. For the US, since 1977 when the 30-year bond was introduced, the average spread between the 30-year and the ten-year has been 0.28 percentage points and 0.34 percentage points between the ten-year and the five-year. True, spreads have been very volatile (see chart) and sometimes gone even lower.

Still, when starting from these yields, there isn’t much cushion if inflation beats expectations. Buying 30-year bonds now will be the right call if inflation turns out much lower, but on the balance of risks, shorter-term bonds look like better value.

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