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Rising Treasury Yields Quiet Investors' Concerns -- Update

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11/14/2019 | 02:19pm EST

By Daniel Kruger and Sam Goldfarb

Yields on U.S. government bonds have rebounded from near-historic lows hit just two months ago, sending one of the clearest signals yet that investors' recent recession fears have waned.

A series of developments have combined to boost the economic outlook, spurring selling in bonds and powering a steep climb in the 10-year Treasury yield -- a key benchmark that helps set borrowing costs on everything from corporate debt to mortgages. Those include the Federal Reserve's cuts to short-term interest rates, steps toward a trade agreement by the U.S. and China and a series of economic reports that turned out better than some investors had feared.

The yield on the benchmark 10-year U.S. Treasury note Wednesday settled at 1.870%, according to Tradeweb. That was up from 1.75% at the start of last week and in early September at below 1.5%, when fears of a global economic slowdown drove investors to the relative safety of government debt. Yields rise when bond prices fall.

The yield's climb marks a significant reversal for the bond market. At one point this summer, U.S. yields were falling so quickly that some investors and analysts wondered if they could drop below zero, joining the trillions of dollars of debt with negative yields around the world. Yields on longer-term Treasurys also slipped below shorter-term yields, a phenomenon known as an inverted yield-curve, which has proved one of the financial markets' best predictors of a looming recession.

Highlighting the turnaround in sentiment, the amount of negative-yielding bonds has dwindled by several trillion dollars. And the U.S. yield curve has almost completely uninverted, with yields on benchmark Treasurys getting progressively higher from the 12-month bill all the way to the 30-year bond.

The 10-year yield remains very low -- sitting closer to the all-time low of 1.366% it reached in 2016 than the 3.2% level it briefly hit about a year ago when the Fed was still raising interest rates. And few investors expect the yield to climb near 3% in the near future, due to slow economic growth and low bond yields overseas, which tend to make U.S. debt look attractive in comparison.

Nonetheless, many investors think yields have room to rise as more people sell bonds to buy riskier assets. The net number of fund managers expecting global economic growth to improve over the next 12 months posted its biggest monthly jump on record in data going back to 1994, according to a survey by Bank of America Merrill Lynch. More than half of those surveyed said stocks will be the best-performing asset class in 2020, while only about 5% picked government bonds.

"Based on the current state of the economy, yields are probably still too low," said Gershon Distenfeld, co-head of fixed-income at AllianceBernstein.

Many investors expect the economy to grow at a pace of about 2% next year. While that is slower than the 2.9% growth achieved last year, it stands in line with recent long-term trends and is a far cry than the contraction investors worried about earlier in the year.

Increased risk-taking is just one reason why a brighter economic outlook is denting bond prices. Continued growth could lead to higher inflation, which is a major threat to longer-term bonds because it erodes the purchasing power of their fixed payments. It could also at some point cause the Fed to start raising interest rates again, pushing up short-term yields in particular.

The average inflation rate investors expect during the next 10 years -- measured by the gap between the yields of 10-year U.S. government debt and Treasury inflation-protected securities of similar maturity -- has risen to about 1.7% from roughly 1.55% at the end of last month. The 10-year break-even rate climbed 17 basis points over six sessions at the start of the month, its largest six-day gain since November 2016.

In congressional testimony Thursday, Fed Chairman Jerome Powell said the U.S.-China trade battle had contributed to declines in domestic manufacturing activity and that uncertainty stemming from the conflict had generally weighed on business sentiment.

Still, he reiterated his view, expressed before a separate congressional panel on Wednesday, that the economic outlook remains favorable, in part because of the Fed's rate cuts. He indicated the central bank was comfortable with the current level of interest rates, barring a change in the economic outlook.

Mr. Powell also played down the risk of much higher inflation, saying he saw "no sign that things are overheating or anything like that."

While the pace of U.S. job growth has decelerated and manufacturing output has weakened, consumers -- who account for more than two-thirds of U.S. economic activity -- have continued to fuel the economy with their spending. Further boosting investors' optimism, the U.S. and China have moved toward what has been billed as "phase one" of a trade agreement, notwithstanding occasional tensions during negotiations.

"Phase one, whatever it is, is a positive for business" and the broader economy, said Anne Mathias, an interest-rate and currency strategist at Vanguard Group.

Many investors still expect the rise in U.S. yields to be constrained by low bond yields overseas, where data in Europe has shown an economy struggling with low inflation and weakening manufacturing output. Foreign investors are buying Treasurys at the fastest pace in almost a decade, attracted by a 10-year Treasury yield that stands more than 2 percentage points higher than German debt of the same maturity.

Still, yields in France and Belgium rose above zero last week for the first time in months, lifted by the European Central Bank's September move to cut interest rates and resume bond purchases. Progress toward a trade deal between the U.S. and China could also provide a boost to government debt yields in Europe, because export-driven economies such as Germany's have been hard-hit by slowing growth in China stemming from rising tariffs, said Jeffrey Elswick, director of fixed income at Frost Investment Advisors.

"The data's going to get better in the U.S. and globally," which could push the 10-year Treasury yield as high as 2.5% next year, he said.

Even with the increase in Treasury yields, the environment remains very favorable to most corporate borrowers. Thanks in part to strong demand for corporate debt, the average U.S. investment-grade corporate bond yield was roughly 3.0% Tuesday, up from around 2.8% in early October but still down from 4% in January.

Underscoring the ability of companies to borrow large sums, the drugmaker AbbVie Inc. sold $30 billion of bonds Tuesday to help fund its acquisition of Allergan PLC. That marked the fourth-largest investment-grade corporate bond sale on record, just ahead of Comcast Corp.'s $27 billion sale last year.

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Write to Daniel Kruger at Daniel.Kruger@wsj.com and Sam Goldfarb at sam.goldfarb@wsj.com

Stocks mentioned in the article
ChangeLast1st jan.
ABBVIE 0.30% 86.98 Delayed Quote.-5.65%
ALLERGAN PLC 0.16% 186.37 Delayed Quote.39.44%
BANK OF AMERICA CORPORATION 1.75% 33.67 Delayed Quote.36.65%
COMCAST CORPORATION 0.45% 44.24 Delayed Quote.29.93%
HUDSON'S BAY COMPANY -0.98% 9.13 Delayed Quote.25.24%
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