Chart of the week: Bond yields are r ising – and central banks are watching

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●  Improving outlook: The ongoing surge in SARS-CoV-2 cases on both sides of the Atlantic will distort the global economic upswing over the winter. But despite the growing near-term risks, forward-looking financial markets are reacting positively to two developments that will shape the global upswing further out. First, the US has elected a more conventional and predictable president (Democrat Joe Biden) along with a mixed Congress that will constrain the risk of premature tax hikes, which could otherwise harm US economic performance. Second, that a vaccine could be rolled out within a few months supports the hope that life can return to more normal by spring 2021.

●  Cause and effect: The rise in government bond yields (10-15bp during the past week for major advanced economies) reflects a sharp fall in medium-term uncertainty, as well as improved expectations for growth and inflation. On its own, the rise in bond yields constitutes a tightening of financial conditions. However, the improving underlying fundamentals that underpin the increase will far outweigh any drag from the modest rise in yields so far.

●  How much can yields rise? Bond yields may rise only modestly further until the US and Europe are through the current wave of the pandemic. Despite the recent uptick, yields on 10-year government debt remain close to historic lows in the US (0.88%), Germany (-0.55%), the UK (0.32%) and France (-0.31%). The emerging gap between US and UK bond yields compared to core Europe probably reflects the pace of government debt issuance – higher in the UK/US versus Germany/France – rather than a difference in growth expectations. Over the course of 2021, we expect benchmark yields to rise by up to 60bp from current levels. Once again, such a modest rise would be no cause for concern. Higher nominal interest rates that reflect higher inflation expectations and a stronger appetite for risk – thus reducing demand for safe government bonds – usually go hand in hand with rising demand for capital goods and credit. Â

●  The role of central banks: Major central banks including the Fed, the ECB and the BoE will be paying close attention to the trends in bond yields and the signals they contain. In no small way, the rise in yields reflects monetary policy success. Following a historic collapse in economic activity in spring, markets are now beginning to price in the sustained recovery to come. However, as the upswing remains young and fragile, central banks will see to it that benchmark yields do not rise to such an extent that they could throttle the uncertain recovery. The Fed’s open-ended QE, the BoE’s latest announcement to buy bonds through the end of 2021, as well as the likely announcement by the ECB to add additional €500bn purchases to its PEPP envelope at the December meeting reflects such a commitment by policymakers.

●  The sweet spot of the cycle: The current backdrop for financial markets is auspicious. Advanced economies are set up for several years of above-trend growth at low rates of inflation, supported by aggressive fiscal and monetary policies. The positive developments in US politics as well as the vaccine hopes tilt the risks to the upside. An ending of Brexit uncertainties in the coming months can add to the positive backdrop for Europe. For how long this can last partly depends on when markets begin to price in a more serious rise in inflation and, correspondingly, for how long and hard central banks will lean against such expectations. Central banks cannot keep bond markets at odds with economic fundamentals forever. But, in our view, the favourable backdrop can probably persist through 2021. Thereafter, central banks could begin to allow benchmark rates to rise faster as a partial correcting force against growing inflation risks.Â

Holger Schmieding

Chief Economist

+44 20 3207 7889

holger.schmieding@berenberg.com

Kallum Pickering

Senior Economist

+44 20 3465 2672

kallum.pickering@berenberg.com

Florian Hense

European Economist

+4420 3207 7859

florian.hense@berenberg.com

Disclosures

This material is intended as commentary on political, economic or market conditions for institutional investors or market professionals only and does not constitute a financial analysis or a research report as defined by applicable regulation. See the "Disclaimers" section of this report.

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