Why are yields rising in the bond markets despite the RBA’s best efforts?

Finance & Fury Podcast

Welcome to Finance and Fury. This episode we will be looking at what is happening in the bond market, how the RBA is struggling to maintain their targets on bond yields for 3y and 10 year - as well as some of its implications on the debt markets and government.

What is going on?

1. over the last few weeks there has been a surprise to the markets – the emergence of a higher 10-year rates on government bonds – the rates went up about 0.45% in Feb and 0.55% since the start of the year
2. This was pretty surprising but it actually does make sense in a way – why?
3. To start with – all we have to do is look what has occurred over the past year –
   1. Looking back on 2020 there was an unprecedented level of stimulus policies - both fiscal and monetary – QE, corporate bond purchases, ZIRP, stimulus payments
   2. The RBA announced on Feb 1 that they were doing an extension to its QE program that they started last year by a further A$100 billion -
      1. They have also said it doesn’t expect to increase interest rates until 2024
      2. Both of these are in pursuit of the central bank's yield curve control – as the RBA is trying to target the three-year yield rate at 0.10%
   3. The same day as the QE extension announcement, the RBA purchased A$3BN in three-year government bonds
      1. This was done in the secondary market and completed on Thursday last week - $3bn might not sound like a lot in the modern era of trillion-dollar stimulus measures - triple the normal amount –
      2. the yield on the April 2024 bonds (maturity of the 3-year bonds) declined slightly from 0.13% to 0.125% - decline of about 4% - but then yields soon jumped up to 0.14% before reverting back to their original yield of 0.13% - but remember they are trying to target a yield of 0.1%
   4. The RBA is in scramble mode to try and control the yields – through their methods of the Yield Curve Control target of 0.10% on the 3Y
      1. Why are they trying to keep rates low? Government funding costs – if you are deficit spending on billions of dollars, the difference between 0.1% and 0.2% is huge
      2. The RBAs success and their credibility are starting to fall short on their target - A$3BN of additional QE proved insufficient to get the yield down to the target – as the 3Y Australian bond rate is still at 0.13% - 3bps above
      3. It is starting to appear that the RBA's Yield Curve Control is failing as the market is pressuring the central bank's commitment to the point of failure – Free market of bonds – not huge selling of local government bonds in recent days, but there was not a lot of buying. When there is less demand for bonds, bond prices fall and yields rise.
      4. So to try and keep yields low – there needs to be more demand which can artificially be created by extensions on QE – or central banks buying back bonds on the secondary market
   5. To date though - RBA had been unsuccessful in lowering yields to the levels they want – they have certainly lowered bond yields – but these are still above what they are hoping at the short and long end of the curve – i.e. the 3y and 10y bonds
      1. There is naturally an upward pressure on market interest rates – so unless the RBA can get this under control – this will flow through into making it more expensive for Government to borrow – as well as companies to borrow over a 3-to-10-year timeframe
         1. This probably won’t affect you or I with mortgage rates – these are not priced off the long-term, 10-year bond yields – the rba cash rate is what matters more to mortgage rates
      2. But the Aus governments 10-year borrowing cost has jumped to 1.72% – a doubling of the yield since the RBA officially unveiled its QE program last November
      3. This upwards yield is ideal for investors, but not for the government – could threatened to unravel the local bond market – issue with compounding debts at higher yields is that at maturity, more bonds need to be issued to cover the payment, think of a balance transfer but every time the interest rates outside of the grace period starts to increase – compounding the risks
      4. that is why the RBA took emergency steps to show markets who's boss with the increase in bond purchases – beyond the 3 year bonds, they will take aim at the longer-term debt
      5. the RBA said it is buying A$4BN of longer-dated bonds which is twice the usual amount
   6. However – similar to the 3y yields, the RBA may sit back and watch as their policy has less and less impact in controlling the yields of government debts, as they purchase more and more
      18. the RBA now owns $18.5 billion of the $33 billion April 2024 bond – 3y bonds issued
      19. As previously mentioned, The RBA have said they don’t expect the cash rate to rise until at least 2024 – but the bond markets are challenging this idea as well - The market is pricing in a jump in rates - with the yield on the November 2024 bond blowing out to 0.36%
      20. This has lifted Aus bond rates quite a bit higher than US yields and that means that there will be probably more demand and more buying of Australian bonds - pushing up the Australian dollar
      21. The rising AUD also puts pressure on the local economy, and stability of exports in a recovering economy – which puts pressure on the RBA as well to further control interest rate expectations
   7. What can the RBA do? They might need to intervene at the longer-end of bond maturity - with more QE because otherwise over focusing on the short term can have spill over effects in the currency market and start to impact other financial markets – like the share market
   8. At the end of the day, the RBA have just one solution - to step in and buy more and more bonds with further QE
   9. Why is all of this occurring? Why can’t the RBA simply click their fingers and hit their desired targets?
      1. Has to do with something else the RBA targets as their primary purpose on monetary policy – inflation targets – something else that central banks are having trouble in achieving as well
         1. Due to the monetary and fiscal policy measures - inflation expectations are beginning to rise – gradually initially – but with front-end interest rates almost guaranteed to be zero by the Fed and other central banks – the nominal yield curve started to steepen and assets that attract risk, such as shares entered into a strong rally
         2. bond traders are beginning to observe higher levels of inflation across the board – therefore, they think it is only a matter of time before Australia yields go up – why yields are trading above targets
      2. To continue looking at this further – to understand why yields are rising requires looking at the relationship of nominal yields, inflation expectations and real yields.
         1. Because higher real yields along with rising inflation expectations can clearly create an environment where nominal yields are rising for good reasons
            1. But the real yields remained depressed through 2020 – real returns are nominal minus inflation – this was at the same time that there were deflationary pressures – the tides are turning at the start of this year – and inflation trades can be seen everywhere
         2. Looking at the real rates - the composition of the nominal 0.55% increase in the 10-year yields since the beginning of 2021, about 0.20% is from higher inflation expectations and 0.35% is from higher real yields – this has been reflected in the equity markets as well
         3. Yields – nominal versus real. Real yields = nominal bond yields minus inflation – these have soared recently
            1. The 10-Year real yield has risen 40BP – gone from -1.06% two weeks ago to -0.67% last week – this negative real yield is the highest it has been in 8 months
            2. So is this due to inflation moving or nominal rates? Both - inflation expectations have risen, but nominal bond yields have tripled – gone from 0.50% in August last year to around 1.50%

• At this stage – this rise in nominal rates is the major reason for why real yields are soaring

1. But inflation expectations are beginning to rise at a greater rate – looking at supply shocks coupled with fiscal stimulus plans in the US and worldwide – in the figures of trillions of dollars that are being financed by the government issuing bonds – inflation is expected to follow – whether it does or not, time will tell
2. But if inflation does materialise – CBs have another policy response – increase interest rates – this is what is being priced into yields for bonds longer term – where there is an upwards pressure on yields
   1. Interest rate relationship to bond prices – rates go up, then the price of bonds goes down, pushing yields up
   2. So the expectation of inflation and the response by CBs is putting pressure on the nominal rates
3. But without constant central bank intervention - the huge increase in bond issuance to finance more and more stimulus spending would naturally push yields even higher – prices go down so yields go up – supply and demand 101
   1. So to avoid governments going insolvent based on the annual interest cost alone, CBs have no choice but to constantly increase their QE programs – either that or collapse the debt markets
4. Also, in basic economics - real yields and inflation expectations rise together when investors expect a stronger, sustained economic recovery –
   1. From what economists expect in regards to economic recovery through looking at the data - this process has already begun and an improvement in economic data would then encourage real yields to make nominal yields go up
   2. One bit of supporting evidence in this is the increase in commodity prices: iron ore prices have gone beyond $US175 a tonne - the highest level in a decade – this has also contributed to upward pressure on the local exchange rate over the past few months, but is also a big reason for the higher yields in bonds
5. So how high could bond yields go – helps to look long term – looking at the 30-year bonds
   1. There is a monthly chart for the 30-Year Treasury Yield that shows that every time the yields exceeded its 100-Month Moving Average, the yields reverted back – this relationship is incredibly reliable -
   2. The yields are currently heading back up – the 100-month moving average is currently around 2.75% - current yields are at 2.32% - so if history repeats itself, the yield may go to 2.75-3.00% and then down again
   3. This relationship may be due to two reasons – self-fulfilling prophecy where traders can take adventive of this, as well as central banks implementing a Yield Curve Control policy – as they can drive down yields by buying treasury bonds across different maturities
   4. No surprise that to implement this means that CBs would need to print more money to buy back bonds from the secondary market

Summary –

13. Yields are on the rise in government debt – as the 10-year bonds are the risk free assets in financial markets, this could have spill over effects into financial markets – shares could soar in relation to the central bank panic and if QE ramps up further
14. But for the next few years, if not longer, CBs will be doing everything in their power to try and target low yields for debt
    1. Inflation expectations and in response, interest rate increases are being prices in and also pushing up bond yields
15. Help to avoid governments being in financial stress
16. Next episode – look at the flow on effects to sectors of financial markets, the dollar, shares, and commodities

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