Yields grind higher
Investors were closely watching Federal Reserve Chair Kevin Warsh’s speech at Jackson Hole, the Fed's annual gathering of central bankers, policymakers and economists. He was perceived as hawkish, meaning prioritising the 2% inflation goal while judging the labour market as strong.
The US Treasury yield curve flattened, with long-term yields falling, which can be interpreted as increased trust in the Fed. Despite this, bond yields continued to rise across the curve globally during the first part of the week. Investors increasingly expect central banks to raise interest rates further. In the Eurozone, headline inflation rose to 3.3%, which will likely be confirmation for the European Central Bank (ECB) that it needs to raise interest rates next week. Warsh's Jackson Hole speech also lowered the bar for a Fed rate hike at its next meeting on September 16.
Long-term bond yields have returned to levels not seen for decades. 30-year German Bund yields are back to levels last seen during the Eurocrisis. In the UK and Japan, 30-year yields have returned to levels last observed in the late 1990s. The 30-year US Treasury yield remains close to the 5.3% level reached in mid-August, a level last seen in the early 2000s.
Some investors argue that these yield levels are not a problem because we have seen similar levels before. However, governments carried much lower debt burdens then. This means that today’s higher yields will weigh more heavily on budgets, while investors also have a much larger volume of bond issuance to absorb.
Fiscal austerity (reducing budget deficits) is the most obvious solution, but politicians are not likely to pursue it voluntarily. Governments may try to intervene, but without support from central banks through measures such as quantitative easing or yield-curve control, such efforts are unlikely to succeed. Furthermore, central banks generally intervene only when financial stability is at risk, often after yields have spiked.
This is not good news for US Treasury Secretary Scott Bessent. One of Warsh’s ambitions is to reduce the Fed’s balance sheet, meaning the central bank would hold fewer government bonds. Without support from the Fed, efforts by the Treasury to bring long-term yields lower are unlikely to succeed.
Fortunately, central banks are more likely to provide support through interest rate policy. Markets currently price a series of rate hikes into the next year. If inflation starts to come down, those expectations are unlikely to materialise. Then central banks could even lower rates, which would bring yields down substantially.
We think this is a likely scenario, but it does depend on energy prices falling. Developments in the Iran war therefore remain crucial to monitor, and we will also be paying close attention to next week's US inflation reports.