The performance of U.S. Treasuries in 2017 confounded many, as the bonds kept to range-bound trading in the context of both higher growth and rate tightening by the Federal Reserve that went beyond initial market expectations. Therefore, it should come as no surprise that the recent move up in yields has triggered so many reactions, including warnings that we may be at the end of one of modern history’s greatest bull markets for fixed income. Yet, while the specific level of yields is important, the nature of the move and its drivers will play an equal, if not greater, role in determining the broader economic and market effects.
The benchmark yield on U.S. government bonds traded in just a 30 basis-point range for most of last year. The absence of both higher yields and greater volatility in bond markets was notable given what happened elsewhere in markets and the economy.
The 2017 surge in stock prices, including 71 record daily closes for the Dow Jones Industrial Average, would normally be associated with a rise in yields. The same would be true of the recent pick-up in global growth, which is synchronized among the major economies, driven more by genuine economic forces as opposed to financial ones, and increasingly sensitive to reinforcing interactions among consumption, investment and trade. And if that’s not enough to drive yields higher and make them more volatile, surely a more hawkish Fed would have the same effect.
Lots of reasons have been cited for last year’s surprising outcome. These range from the impact of “non-commercial flows" -- particularly purchases of securities by the Bank of Japan and the European Central Bank, as well as liability-driven investing by institutional investors -- to doubts about the medium-term durability of the growth pick-up. And with questions about the continued role of these factors, including the possibility the ECB could taper its purchases at a faster rate, yields have moved up around the advanced world and become somewhat more volatile in the last few weeks.
Where yields end up in 2018 will, of course, have an impact on markets and the economy. They play an important role in influencing market prices, especially the large number of assets that reflect discounted future cash flows. They also affect borrowing, credit and mortgage activities. And, through the foreign-exchange markets, they can have an indirect effect on growth.
At least as important is the way these higher yields are reached. Big jumps tend to be more disruptive then gradual increases, including by heightening the risk of disorderly deleveraging by over-extended and over-indebted households and businesses.
The drivers of higher yields also matter. As an illustration, the possible adverse effects on markets and economy are a lot less severe if a rise is due to stronger inclusive growth as opposed to a central bank policy mistake or a market accident.
So where does this leave us?
Higher and more volatile yields, particularly when compared to those of 2017, should be part of the baseline for this year. This is unlikely to be a runaway process as the influence of central banks, while probably reduced, will still be significant. And pension funds will continue to try to immunize their liabilities, enabled in part by the substantial profits they can now monetize on their equity holdings. The potential for broader disruptions will also be contained by the probability that the main driver will be better growth dynamics -- not just in the U.S. but also in Europe and elsewhere.
Yes, yields are probably heading higher this year absent some major non-economic shock. But this event by itself probably is unlikely to translate into broad economic and financial disruptions.