Bond yields - the old normal?

Anybody asleep for the last 20 years would find nothing unusual in today’s government bond yields. German yields are a bit lower than in 2006 (3% today vs 3.5-4%) while Japan’s yields are a bit higher (2.5% vs 2%). But 10-year US Treasuries and UK Gilts are right in the 2006-7 range. Much has been made of the recent rise in 30-year yields but the 30-year US Treasury is in line with 2006-7 and showing only a modest spread over 10-year yields (see chart). Meanwhile in the UK, the 30-year gilt yield is only about 50bps higher. So, are we back to the old normal?

Not so fast! Yields have jumped since the Iran war started so it is easy to argue that the current level is an aberration which will unwind once (if?) oil prices come down again. Just before the war the US 10-year Treasury was pushing under 4% (4.56% now) while the 10-year gilt yield was approaching 4.2% (4.90% now). But there are good reasons for thinking that – even if the Straits reopen soon and oil starts flowing – yields are more likely to fall only a little from current levels rather than drop back to pre-war levels.

First, medium-term expectations for inflation seems to be inching up. Latest calculations for 10-year expectations (based on bond yields) put them at 2.5%, the highest for many years and just about reaching the range seen in 2006-7. Surveys of consumers suggest that expectations for inflation over 3 years have only inched up this year, to about 3.15%, but this is well ahead of the 2.5% level typically seen before Covid. With inflation running at 2.5-3%, a 4.6% bond yield is not especially high, while the Fed’s projection before the war that the FOMC could reduce the Federal Funds rate to 3-3.25% (3.5-3.75% today) looks a stretch.

Secondly, wage growth in the US is still a little high to be sure that inflation will eventually return to 2%. And unless unemployment rises again, it is not clear that wage growth will slow from here. Indicators such as the Atlanta Fed Wage Tracker and average earnings show wage growth leveling off in recent months after falling since 2022. Worse, with the labour force static due to tight immigration controls, there is a chance that wage growth accelerates again.

Europe also has low unemployment, though the UK labour market has eased considerably in the last two years so probably has a better chance of wages slowing, especially with the Iran war combined with political uncertainty likely to slow the economy.

Thirdly, it is easy to argue that inflationary forces could take hold. The size of the US budget deficit, the fact that inflation has been above the 2% target for more than 5 years and the rise in defence spending world-wide all point to long-term inflation risks. This is likely to keep real yields – the neutral rate if you like – higher than thought before. 10-year TIPS yields have risen over 2%, reflecting this view.

Finally, as Kevin Warsh takes over at the Fed, we know his inclination is to cut rates if possible and to reduce the size of the Fed’s balance sheet. Both of these instincts point to higher bond yields – the first because it risks stronger growth and higher inflation, the second because it points to a steeper yield curve as more government bonds have to be held by the private sector. With the government deficit high and data centre spending also boosting bond issuance, the supply of bonds to be absorbed is high.

Our view is that – in the absence of a significant economic slowdown – even a fall in oil prices back to pre-war levels is unlikely to allow the US 10-year yield to go below 4%. The technical view - see my colleague Gerry Celaya’s recent blog - also points that way. I see the 4-5% range as the new normal – much like the old normal. Get used to it!