Global investors can now add rising 10-year sovereign debt yields to their growing list of concerns. In addition to higher yields, they are being confronted with recent dollar strength and heightened currency volatility in the foreign exchange market, weak first-quarter U.S. GDP growth, suppressed crude oil prices, and the deteriorating effect that the aforementioned factors collectively have on corporate profitability, particularly in the energy, materials, and industrial sectors.
The timing, short-term duration, and magnitude of the uptick in bond market yields have turned out to be extremely thought-provoking. In Europe, German bond yields have risen to as high as 73 basis points (bps) on May 13 from a miniscule 8 bps on April 20. This move is nearly as startling as last year’s sharp 7% ascent of the U.S. dollar index and the 56% collapse in crude oil prices.
The largely unanticipated increase in European M3 monetary aggregate growth appears to have sparked the increase in German note yields because it suggests that the European Central Bank ‘s (ECB’s) quantitative monetary stimulus may be gaining traction more quickly than global fixed-income investors previously envisioned. Having commenced open market fixed-income security purchases as recently as two months ago on March 9, investors appear to have been caught off guard by preliminary signs of policy success that the 6% year-on-year rise in M3 money implied. However, we remain a long way from downstream confirmation that the ECB has actually neutralized risks of outright deflation, considering that as of March data, eurozone core inflation is still suppressed at +0.6% and eurozone unemployment remains historically elevated at 11.3%.
Ten-year Treasury note yields are being driven higher by speculation that the data-dependent Federal Reserve could tighten U.S. monetary policy in September, in addition to some sympathy with rising rates in Europe. The timing of the increase in U.S. interest rates is a bit puzzling considering that Fed officials have stated on multiple occasions that a tightening of monetary policy will only occur when the Federal Open Market Committee (FOMC) “is reasonably confident that inflation will move back to its 2% objective over the medium-term.” According to the Fed’s economic projections released after the March FOMC meeting, the Fed doesn’t see inflation returning to 2% until sometime in 2017. Nonetheless, the resumption of healthy U.S. non-farm payroll growth in April (+223,000) has rekindled speculation that the Fed could conceivably initiate the long-anticipated normalization of U.S. monetary policy should the pace of job creation continue improving during the course of this year.
With European monetary aggregates displaying preliminary signs of life, the spike in German 10-year note yields is reasonable when viewed against underlying European core inflation of 0.6%. At this point, with 10-year yields 13 bps above, as opposed to substantially below, core inflation, additional upside for yields appears limited until European inflation shows evidence of at least establishing a base and thus raising the possibility of eventually reversing course to the upside. For 10-year U.S. Treasury notes, inflation-adjusted yields now exceed 50 bps relative to the March reading of the core Consumer Price Inflation at 1.75%. Additional significant upward pressure on the term structure of U.S. interest rates likely requires sustained, robust U.S. economic data.