Risks in the US bond market

US bond yields are at 40-year lows, and still investors fall over their feet to snap up more US Treasuries.

An article in The New York Times on September 9 1981 indicates how US bonds (10-year and 30-year) were trading at 15% at that time.

Ironically, the article states: “Long-term Treasury bond yields rose briefly to 15% yesterday, but even that record yield for a 30-year bond backed by the United States government was not enough to attract much investor buying.”

Back then, 15% could not attract any buyers; today, the yield is down to 1.43% (as at the end of June 2020) and investors continue to buy.

It could be that since July 2018, 30-year Treasuries have handsomely outperformed both Amazon shares and the gold price index, returning almost 60%. In fact, these bonds have become so popular that even the twoyear yields are now threatening to turn negative — meaning you will pay interest on your investment and not earn interest.

When comparing data from 1971 until the present, both real and nominal yields are at historically low levels.

This accommodative monetary policy environment has been fuelling a massive bull market in US Treasuries over the past halfcentury. Yields have also declined in line with lower interest rates.

As the US Federal Reserve embarked on more monetary support, the yield curve has become even lower and flatter. Negative real yields (negative yields after accounting for inflation) across the curve are now a real possibility, while all data points to yields threatening to turn negative on the shorter end of the curve.

To mitigate this risk, US policymakers have mentioned the possibility of using a tool last used during World War 2 — a measure called “yield curve control”.

The Fed adopted a yield curve control policy in April 1942 to assist the US Treasury’s financing of World War 2. Quite like today, at that time no-one really knew if this policy would work.

As the name implies, the strategy essentially involves government intervention in the form of bond purchases to keep yields at predetermined levels. So, if the Fed wanted the yield on the 10-year note to be 50 basis points, for example, they would buy or sell enough bonds in the open market to shift yields to that level.

We can think of it as quantitative easing through bonds purchases that are specifically aimed at reaching specific yields for specific bonds.

Ultimately, investors may end up being protected if these measures come into play, something Australia started experimenting with, in March this year. The trade-off, however, will be a severely bloated US balance sheet, which is already stretched past the $7-trillion (R120-trillion) mark.

One must wonder what will become of the US balance sheet. And what will the market reaction be once yield curve control comes to an end (if it is introduced)?

Ultimately, the market will have to restore its natural supply and demand price dynamics. In a similar vein, we too are somewhat sceptical of the long-term impact of yield curve control. This could severely bloat the US balance sheet. Yet, in the absence of that, the near-term risk to the bond market remains material.

The Fed adopted a yield curve control policy in April 1942 to assist the US Treasury’s financing of World War 2