To the casual observer, U.S. economic conditions may look like more of the same. That is to say, despite solid growth and a tight labor market, inflation remains muted and bond yields are stuck in a broad range. At 2.40%, yields on benchmark 10-year Treasuries are well below their highs of the year of just above 2.60% reached back in March.
So, nothing to see here, right? Wrong. The case for higher bond yields is getting stronger by the day. The bullish argument for Treasuries has mainly rested on the recent trend of inflation data coming in below forecasts. But Federal Reserve policy makers have made it clear that they expect the trend to reverse with inflation rising to their 2% target.
At the same time, policy makers have sent signals that they believe financial conditions are too loose, requiring them to further remove some accommodation. That theme should only intensify as President Donald Trump puts his stamp on the central bank, which is likely to be more hawkish in its approach.
Put all this together and traders are pricing in an 84% probability of another 25-basis-point increase in interest rates in December. Those odds have battered the short end of the Treasury market. The U.S. government will auction $26 billion of two-year notes on Tuesday at a yield of close to 1.60%, up some 30 basis points from where they were in early September and the highest since late 2008.
What about the steady flow of money into Treasuries from deep-pocketed investors and foreign sovereign reserve managers seeking an alternative to the puny government bond yields in the euro zone and Japan? Their influence on U.S. rates won’t go away soon, but the trend is toward tighter global monetary policies. For example, the European Central Bank on Thursday is expected to detail a plan to taper its bond purchases. As European rates readjust higher, global cash could shift away from dollar-denominated bonds.
The Fed is much further along in the process, having already started shrinking its balance-sheet assets this month. As the Fed reinvests less of the proceeds from maturing bonds that it holds back into the market, the Treasury Department will need to find other buyers for about $200 billion of the bonds it plans to sell next year. That’s on top of the large increase in the budget deficit, which grew to $665.7 billion in the fiscal year ended Sept. 30 from $585.6 billion for the 2016 fiscal year.
Those two shifts in the supply pattern in Treasuries should pressure rates higher across the yield curve just as the government ramps up bond sales in early 2018 to pay for the wider deficit shortfall. We could get a sense of what’s to come as soon as Nov. 1, when the Treasury announces the sizes of the next three-, 10-and 30-year bond auctions.
Bond bulls might point to the poor correlation between deficits and bond rates in the recent past, but this is a different environment because of the unique circumstance of the Fed and its balance-sheet plans. Fed policy makers have downplayed the relevance of the reduction because they have to after the experience of the so-called Taper Tantrum in 2013 that roiled markets. They are extra sensitive to market disruptions, especially with questions about the “depth” of the Treasury market due to the big primary bank dealers cutting back on staff in recent years and new stringent regulations that curb their ability to trade.
Then there is the flattest yield curve in nine years to consider. The bulls point to this as a sign that the Fed is making a policy mistake by raising rates, but again this traditional barometer looks less useful when short rates have been left at zero for so long and global quantitative easing has distorted term premiums. The government is likely to report on Friday that gross domestic product expanded at a healthy 2.5% to 3% annualized pace last quarter, more than enough to keep downward pressure on the already-low unemployment rate.
Finally, the odds remain decent for some form of tax cut or reform package that will add to the deficit, as the Republicans need a big political win and budget discipline is not the priority.
The confluence of tighter Fed policy, Washington budget dynamics, stable economic growth and global monetary tightening should keep upward pressure on U.S. rates and bond yields into 2018. There will be hiccups that would cause a rebound in Treasuries — if, for example, North Korea lobs another missile over Japan or the ECB disappoints — but those bounces will be short-lived.
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– Read Ultra-Long U.S. Bonds Can Absolutely Make Sense: Mnuchin on ThinkAdvisor.