Understanding Recent Bond Market Changes: Why Long-Term Yields Went Up and What's Next"

Over the past few weeks, the rates market has experienced significant fluctuations, particularly in long-term yields. For instance, the yield on the US 30-year government bond was at 3.82% on July 19th, but just a month later, on August 21st, it reached a high of 4.448%. This represents a substantial increase of more than 60 basis points in a very short period.

Similarly, the yield on the US 10-year government bond was 3.75% on July 19th and rose to 4.36% by August 22nd, also marking a 60 basis point or more increase.

Contrastingly, the 2-year yield only saw around 25 basis point change during the same period. This deviation from the usual pattern, where long-term bonds typically lead bond sell-offs, is termed "bear steepening." It describes a situation where longer-term yields rise faster than short-term ones, causing the yield curve to steepen.

Now, let's delve into the reasons behind these developments. Several factors have been identified by analysts:

1.Bank of Japan's Yield Curve Control Policy Adjustment: The Bank of Japan (BOJ) made changes to its Yield Curve Control (YCC) policy. In simple terms, the BOJ had previously limited the yield on 10-year Japanese government bonds to 0.5%. However, in a recent monetary policy meeting, they raised this cap to 1%. This adjustment matters because Japanese investors are major holders of US Treasury bonds. With Japanese bonds now offering more attractive returns, these investors are inclined to favor Japanese bonds over US Treasuries, leading to a sell-off. As bond prices fall, yields rise.

2. Fitch's Downgrade of the US Credit Rating: Fitch, one of the largest credit rating agencies in the world, downgraded the US credit rating from AAA to AA+. This downgrade also contributed to the bond sell-off.

3. Increased US Borrowing Estimates: The US disclosed its borrowing estimates, revealing a significant increase in the issuance of bonds. Essentially, the US will be issuing a substantial amount of bonds, which can result in investors demanding higher yields. When supply outpaces demand, it creates a fundamental economic mismatch.

4. Robust US Economic Growth: Despite expectations of an imminent recession due to the Federal Reserve's aggressive interest rate hikes over the past year, the US economy has demonstrated remarkable resilience and strong growth. The US economy is currently projected to be growing at an annualized rate of 5.6% in the third quarter of 2023 according to Atlanta Fed GDP Tracker. Economists are speculating that if this high growth persists alongside elevated interest rates, it could indicate an increase in the "neutral rate," the level at which the economy neither accelerates nor decelerates. The Federal Reserve has managed to bring down inflation in recent months, but sustained high growth carries the risk of inflation resurfacing. Therefore, the Federal Reserve is hoping for a slower pace of growth to ensure that inflation remains close to its target of 2%.

What's happening now?

Indeed, there has been a correction in longer-term yields. At the time of writing this, the 10-year yield, which reached a high of 4.36%, is currently trading at 4.22%. Similarly, the 30-year yield, which peaked at 4.448%, is currently at 4.31% . Despite this correction, these yields remain significantly higher than what was considered normal just a few months ago. It raises the intriguing question of how these longer-term yields will perform in the near future. Will we witness a substantial and sustained shift in these long-term yields, with them remaining elevated for an extended period? Alternatively, could we see a reversal of the recent fluctuations in the coming weeks? The answer is uncertain, and we will need to closely monitor the situation to discern the market's future direction.