As the curtain falls on the era of pandemic-induced easy monetary policy, bond markets are readjusting. The US Federal Reserve has all but confirmed that it will start to taper its monthly purchases in November 2021, taking its foot off the accelerator so to speak. The Fed’s own projections also pointed to the possibility of interest rates going up in 2022, earlier than previously indicated.
US Treasuries have since sold off heavily, with 10-year bond yields rising to their highest level since June and triggering a decline in equity markets, before falling slightly at the end of last week. While this was largely due to the more hawkish tone from the Fed at its September monetary policy meeting, uncertainty around US legislative processes also contributed to last week’s sell-off in bonds.
In the UK, the Bank of England has also given indications that it was preparing to tighten policy due to mounting inflation pressures affecting the economy.
The governor of the BoE went so far as to suggest the central bank could raise rates as soon as November, even before the end of its asset purchasing programme. In the background, at least for developed markets, Norway’s Norges Bank raised rates by 25bps in September and lined up another hike for December.
Barring any substantial deterioration in economic conditions in either the UK or US economy, the likelihood of yields remaining high or pushing even further upwards looks strong. Emirates NBD forecasts the 10-year US treasury yield to be 1.75 per cent by December-end while 10-year gilt yields have already pushed beyond our expectation of 0.9 per cent by end of the year.
Tighter monetary policy, elevated (if transitory) inflation and expectations for continued economic growth will help support yields rising into 2022 as well.
But downside risks to yields remain apparent and these are largely policy-related. While the passage of last-minute legislation avoided a US government shutdown at the end of September, Democrat party infighting threatens their own legislative agenda while Republicans show no apparent urgency to support plans to raise the debt ceiling.
Longer-dated US treasuries could benefit from a flight to safety bid if there is anxiety that the US Treasury will fail to meet any payment obligations. We think a US default on debt payments is unlikely, but the longer this process takes, the greater the chance of a policy error.
Another downside risk for US treasury yields is slowing growth. Economic data has been mixed in recent weeks, with manufacturing holding up well while services sector growth has slowed as the Delta variant of the coronavirus continues to spread.
Weekly initial jobless claims increased in the latest reading and consumer sentiment is back near the pandemic lows of the second quarter of 2020. All eyes will be on the September non-farm payrolls data, which is due later this week after a much lower than expected jobs gain in August.
In the UK, the BoE will have to monitor the labour market implications of the end of the government’s furlough scheme, which expired in September. A surge in unemployment at a time when inflation is being driven higher by energy prices and supply chain disruptions could stay the BoE’s hand on wanting to move tighter on policy.
Beyond developed markets, tighter US monetary policy will weigh acutely on emerging markets too. An index of dollar-denominated emerging market bonds has declined 1.8 per cent since the middle of September with the yield rising to the highest level in over a year.
Pressure will grow on emerging market central banks to maintain inflows and potentially tighter policy further at a time when many of their economies are still early in the stages of pandemic recovery or vaccination programmes. The risk for emerging market assets, whether in FX or bond markets, looks broadly negative in the near term.
Khatija Haque is chief economist and head of research at Emirates NBD