Last week was tough for US Treasury bonds, the IOUs issued by the US government to pay for that portion of federal spending not covered by tax revenues.
As Dominic O’Connell noted here on Saturday, yields on Treasuries (which rise as the price falls) rose sharply after Moody’s became the last major ratings agency to downgrade America’s credit rating from the highest level, while Donald Trump’s “big, beautiful bill” came a step closer to being enacted and, with it, raising government borrowing by an estimated $3 trillion to $4 trillion over the next decade.
A third — and important — factor driving the sell-off was that an auction of $16 billion worth of 20-year Treasuries on Wednesday drew only weak demand, implying a reluctance on the part of some investors to lend to Uncle Sam. Investors demanded a 5 per cent coupon (interest payment) for the risk they were taking on.
What was particularly interesting about the move in Treasuries, though, was where on the yield curve (the graph that plots the yields of bonds of identical credit quality but differing maturities) the big adjustments took place.
During the course of the week, the yields on two-year Treasuries and on five-year Treasuries barely moved. The sell-off occurred at the “longer” end of the curve, with the yield on ten-year Treasuries rising by 0.071 percentage points, to 4.509 per cent, while the sharpest increase of all saw the yield on 30-year Treasuries, the so-called long bond, rise by 0.141 percentage points to 5.05 per cent, having at one point on Thursday jumped to 5.161 per cent, a level last seen in October 2023.
This increase in the yield on the long bond — traditionally seen as one of the safest of safe havens for investors — matters because it invariably has an impact on borrowing costs for US households and businesses. The move has also unnerved market professionals because the yield is now flirting with levels last seen during the start of the global financial crisis in 2007.
This widening in the gap between short-dated and long-dated yields, known in the industry jargon as “yield curve steepening”, is also significant.
A steepening may not necessarily be bad news if it reflects a view among investors that an economy is set for higher growth. In this instance, though, it reflects concerns about inflation.
As David Sadkin, president of asset manager Bel Air Investment Advisors, told The Wall Street Journal last week: “The bond market is basically saying inflation remains a significant risk to the economy … this is the highest level of uncertainty I can remember in at least the past 17 years. I think you have to go back to the financial crisis to get this level of anxiety.”
Yet yield curve steepening is not just a US phenomenon. It is also being seen in a number of advanced economies, including Germany, Japan and the UK. For example, the yield on 30-year German bunds, which was negative at the end of 2021, stood at 3.111 per cent at the close on Friday evening.
The reason for this steepening varies from country to country but there are common factors, as Ralf Preusser and Sphia Salim, rates strategists at Bank of America, observed in a note, Big Bang Bond Steepening, published on Wednesday last week.
They told clients: “Common global drivers of this trend are: high government financing needs; shrinking central bank balance sheets (amplifying the effect of rising government bond supply to the private sector) and a fall in duration demand from liability driven investors.”
This will have implications, they argue, for how countries like the UK borrow money on the bond markets in future.
Yield curve steepening matters for the UK because its debt burden is, on average, longer dated than a lot of peer economies. It means that, when the gap between short-dated and longer dated debt widens, the UK is effectively paying more to service its debts.
The UK’s steepening can be explained by several factors. Defined benefit pension scheme deficits have halved from a peak of £2 trillion, while there are now fewer people drawing a retirement income from such schemes and, as the BoA team notes, they are ageing rapidly. Total membership of defined benefit pensions schemes fell by 16 per cent between the third quarter of 2019 and the first quarter of last year. Apart from ageing, this is also due to the widespread closure to new members of private sector defined benefit schemes after former chancellor Gordon Brown’s notorious tax raid of 1997.
At the same time, the mix of assets held by such schemes is already predominantly geared towards gilts, UK government bonds.
That means there is potentially less demand for the longer-dated gilts that pension schemes traditionally bought to meet their expected future liabilities (the LDI, or Liability Driven Investing, strategy that was at the heart of the blow-up in gilts following former chancellor Kwasi Kwarteng’s mini-budget in September 2022).
In response, the BoA team argues, the Debt Management Office (DMO), the Treasury agency responsible for gilt issuances, may seek to lower the average maturity of gilts, perhaps with a little help from the Bank of England, via changes to how the latter is unwinding the bond portfolios it built up under quantitative easing.
Mark Capleton, the UK rates strategist at BoA, has a number of suggestions. Among his most interesting is that the DMO could limit and then suspend long-dated gilt issuance.
This is something Sir Geoffrey Howe, arguably Britain’s greatest post-war chancellor, did in the early 1980s with the main motivation of bringing down long-term borrowing costs. But it also had the benefit of stimulating the market in corporate bonds — where activity had been “crowded out” by heavy government borrowing.
Such a measure, were it to be repeated, could well have the same impact. And that, if it stimulates more risk-taking and particularly in longer-term projects such as infrastructure investment, is something Rachel Reeves, the current chancellor, would find very welcome.
Ian King is a presenter for Sky News. Ian King Live is broadcast from 10.00-11.00, Monday to Friday