US Bond Market’s Unpredictability by Barry Eichengreen



The interest rates on ten-year US Treasuries have reached nearly 5%, more than triple the levels from two years ago, making bond yields attractive once more. Despite a difficult few years for investors in US Treasury bonds, the “smart money” is now returning, with the expectation that interest rates will fall and bond prices will recover as inflation fears subside. Nevertheless, substantial uncertainty remains, influenced by factors such as geopolitical uncertainty and the supply of debt.

Optimized Bond Market: Interest rates and Bond Yields

With interest rates on ten-year US Treasuries close to 5%, more than triple the levels of two years ago, US Treasury bonds are becoming attractive investments again. If the fundamental factors driving them remain stable, it’s possible that interest rates will fall and bond prices will recover now that the inflation scare has subsided.

However, the recent years have been a disaster for investors in US Treasury bonds. By some accounts, 2022 was the most challenging year for such investors since 1788. Bond prices are projected to decrease yet again in 2023, marking the first time in US history that they have dropped for three consecutive years.

Despite this, the “smart money” is showing renewed interest. With the interest rates on ten-year Treasuries at 5%, yields are appealing. If the factors driving them remain consistent, there’s a chance that interest rates will drop and bond prices will recover now that inflation fears have eased.

But the resilience of these fundamentals remains critical. The interest rate on bonds should reflect the underlying natural real rate of interest, plus inflation expectations over the holding period. A range of measures shows inflation at around 3%, undermining concerns of prolonged high inflation that significantly surpasses the Federal Reserve’s 2% target.

The so-called natural rate of interest, also known as r*, is a topic of significant debate, but an agreement is that its determinants change slowly, aligning aggregate savings and investment. The savings rate depends on slowly changing demographic factors: the share of working-age population, and the lifespan of retirees.

We must remember that not only US savings matter. A slowdown in Chinese GDP growth or a shift in China from saving to consumption could also affect the natural rate. Yet, all evidence suggests these structural changes are gradual and ongoing. China’s policymakers take incremental steps, which do not indicate sharp changes in r* over recent years.

Moreover, the New York Fed’s June 2023 estimate shows that r* barely moved in the past two years. Pairing this with recent data on inflation implies that the bond market is oversold.

Geopolitical uncertainty and the supply of debt are two further variables affecting the bond market’s prospects. Historically, such uncertainty has favored Treasuries, which are a safe haven for investors in uncertain times. However, yields have slightly increased recently due to rising geopolitical uncertainty.

The supply of debt is also a significant factor. As the federal government runs persistent deficits, yields will need to increase for investors to accommodate the Treasury’s additional issuance. With increased defense spending and resistance to higher taxes or expenditure cuts, yields may rise to higher levels than investors currently expect before they eventually stabilize.

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