The US Federal Reserve (Fed) is likely to raise interest rates before the end of 2015. At Nikko AM, we believe that this could be as early as September and that there could be a second hike swiftly after, potentially also before the end of this year. However, we think that this will have a minimal effect on longer-term US bonds, including 10-year Treasuries, which will continue to be largely driven by the movement of German bunds.
The Fed has stated that it will increase rates gradually and this will remain data-dependent. If economic data starts to deteriorate after it begins raising rates, it could stop the Fed in its tracks. However, if the US economy continues to strengthen, we could see faster rate rises than the market is currently pricing in. Either way, we believe that the impact on 10-year Treasuries and the longer end of the US yield curve will be mitigated by continuing low bond yields in Europe and Japan as those countries try to ignite their economies via quantitative easing (QE). QE will help to keep the euro and the yen depressed and the US dollar strong, which in turn will somewhat constrain growth in the US economy, leading to only a gradual uplift in rates. The risk to this scenario is if the situation in Europe were to unexpectedly improve, pushing up European and then US bond yields and potentially weakening the US dollar. However, in our view, this is unlikely, particularly given the continuing Greek crisis.
US 10-year Treasuries currently tied to German bunds
The movement in US bond yields over the course of this year highlights their close links to both Europe via German bunds and commodities, particularly energy prices. In the early part of 2014, US 10-year bond yields fell (prices rose) directly following the downward movement in German bund yields as the market anticipated the imminent start of QE in Europe. The expectation for and implementation of European QE put upward pressure on the US dollar since the Fed had already ceased its QE programme and strong US data increased the odds of a rate rise in 2015. This allowed US 10-year Treasury rates to remain well supported, reaching a low in yields at 1.60% as oil prices collapsed (see chart 1).
Chart 1: US 10-year Treasuries vs. 10-year German bunds
The outperformance in early 2015 was quickly reversed as oil prices began to rise again. US Treasuries then suffered a second reversal in May as German bunds rose on stronger European inflation data. The subsequent stabilisation in bund rates is keeping US 10-year Treasury rates bound in a narrow range of 2.20%-2.50%. The fact the Fed is close to raising rates is not having much impact on 10-year yields, which continue to follow German bund moves. This is leading to a flattening of the US yield curve since short-term rates are rising in expectation of Fed funds rate (official interest rate) increases.
Many market commentators have compared the June 2003 rise in 10-year Japanese government bond (JGB) yields to the sell-off of 10-year German Bunds that started in May. In 2003, as JGB yields steadily fell, global bonds followed. After hitting a record low in June 2003, JGB yields began selling off, driving up US 10-year Treasury yields (see chart 2).
Chart 2: US 10-year Treasury yields vs. 10-year JGB yields in 2003
Movements in the Fed funds rate at that time had little impact on US 10-year Treasury rates (see chart 3).
Chart 3: Change in US 10-year Treasury rate vs. actual Fed funds rate
We are currently seeing a similar pattern, with movements in German bunds affecting US Treasuries more than expectations for the Fed funds rate. In our view, this is due to the term premium on US Treasuries compared with bunds.
Any sell-off in US Treasuries is likely to come from a rise in the term premium
Treasury yields factor in two components – expectations of the future path of short-term Treasury yields and the term premium. The term premium is the compensation that investors require to cover the risk that short-term Treasury yields do not evolve as they expected. Looking back at the taper tantrum of 2013, there was a dramatic rise in the term premium for US Treasuries to nearly 2.5%, while the 2014 German bund rally saw it drop again. The recent sell-off has compressed to a very low rate of 0.5%.
As a result, any sell-off in US Treasuries is likely to come from a rise in this low term premium. US Treasuries are currently relatively attractive compared with other sovereigns bonds and particularly German bunds which are offering a much lower yield. Any lift in US 10-year Treasuries yields will more likely be due to rising rates in overseas markets than due to the Fed increasing short-term interest rates.
If we look back to the 2003 example, we can see that JGB yields continued to rise over the course of the year (see chart 4). By contrast, German bund yields in 2015 have reversed their sell-off, which is also keeping US Treasury yields anchored at their current levels. This explains why the US Treasury sell-off in 2015 has been so mild compared with 2003.
Chart 4: JGB yields in 2003-04 compared with current German bund yields
Over the past few months the US 10-year Treasury yield has been range-bound between 2.20-2.50%, largely due to this stabilisation in German bund yields. This is despite the fact that there is increasing market acceptance that the Fed is about to start raising interest rates. Although rate hikes are likely to temporarily pressurise Treasury yields, we believe it will have a minimal impact on long-term bonds compared with short-term bonds. As a result, a flatter yield curve is the likely outcome of the Fed’s actions, with short-term bond yields rising but longer-term yields not reacting greatly. Even though the current term premium on US Treasuries seems too low, it is unlikely to rise significantly unless offshore bond yields start to rise. Unless and until this happens, US Treasuries will remain range-bound.
Impact on Australian bonds should also be minimal
We don’t expect to see another cut in Australian rates unless there is further deterioration in the economy – in our view, rates will remain on hold for a considerable time at these low levels. In the Australian bond market, it is domestic factors that have a much greater influence on short-term bond yields so with the cash rate on hold, 3-year bond yields should not be affected by the Fed’s actions.
On the other hand, the Australian 10-year bond is very much correlated to the US 10-year Treasury rate. Given our view that the Fed’s rate rises won’t have much impact on the US 10-year rate, we don’t expect the Australian 10-year bond to show much reaction either – the impact of rate rises on Australian bond markets should be minimal. What we are monitoring is offshore bonds moves, particularly German bunds, since that will have an influence on US long bonds and subsequently on Australian 10-year bonds.