What’s behind the decline in U.S. bond yields?

On the latest edition of Market Week in Review, Chief Investment Strategist for North America, Paul Eitelman, and Julie Zhang, head of North America sales enablement and analytics, discussed the decline in U.S. bond yields, the European Central Bank (ECB)’s new strategic policy framework and global manufacturing numbers from June.

U.S. bond yields tumble. Is the delta variant partially to blame?

U.S. government bond yields fell sharply the week of July 5, Eitelman said, with the yield on the 10-year Treasury note declining to approximately 1.3% on July 8—its lowest level since mid-February. The drop in yields was a global phenomenon, he added, noting that 10-year German Bund yields sank to -30 basis points at one point during the week.

As for what may be driving the sharp moves in fixed income markets, Eitelman pointed to two potential factors in particular, stressing that in his opinion, neither one appears significant enough to change the overall positive economic and market outlook. The first factor, he said, is the spread of the delta variant of COVID-19, which has led to an increase in infections worldwide.

“Importantly, the latest scientific evidence suggests that the leading Western vaccines still prevent serious illness among individuals who become infected with the delta variant,” Eitelman stated. He added that while there is a risk that the spread of the variant could delay the broader global reopening, it’s unlikely to derail the overall economic recovery. “I still expect pretty strong growth in the U.S. and on a global basis during the second half of the year,” Eitelman said.

The second factor potentially responsible for the drop in yields is concern over a possible policy mistake by the U.S. Federal Reserve (the Fed), he said. Eitelman noted that the central bank’s pivot to a more hawkish tone at its June 15-16 meeting was fairly surprising, with Fed officials indicating two rate hikes may be possible by the end of 2023. However, he believes that markets are probably overreacting a bit to the central bank’s change in tone. “I think what the Fed really was trying to convey was that it’s feeling a bit more confident that the deployment of effective vaccines will continue to drive a strong recovery in growth over the next few years,” he stated. Recently released minutes from the central bank’s June meeting show that Fed officials expressed such concerns about a market overreaction, Eitelman noted, with FOMC (Federal Open Market Committee) members worrying that investors might question the Fed’s commitment to achieving full employment and price stability.

In Eitelman’s view, what the central bank is attempting to employ moving forward is essentially a risk management strategy. “The Fed wants to drive as much strength in the labor market as it possibly can until inflationary pressures force it to begin raising interest rates—and, in my opinion, that’s unlikely to happen until the second half of 2023,” he remarked.

Above all else, Eitelman said, the economic recovery remains on track, and he believes that Treasury yields will gradually rise to a range of 1.5% to 2.0% over the next six to 12 months.

ECB increases inflation target to 2%

Turning to Europe, Eitelman said that on July 8, the ECB announced significant changes to its monetary-policy framework, the result of its first strategic review since 2003. Overall, the changes were dovish in scope, he noted, with the central bank increasing its inflation target to 2% over the medium-term.

“Previously, the ECB was targeting an inflation rate slightly below 2%,” Eitelman said, explaining that allowing for more inflation naturally requires the central bank to keep interest rates lower for longer to achieve such an outcome. The ECB will also allow inflation to temporarily overshoot its 2% target during periods when monetary policy is constrained by short-term interest rates near zero, as is the case today, he added.

Ultimately, these alterations to the ECB’s policy framework should leave the central bank firmly committed to accommodative monetary policy for quite a long time, Eitelman said, noting that the changes are similar to those adopted by the Fed last summer.

Global manufacturing continues to expand

Shifting to the U.S. labor market, Eitelman said that June’s employment report showed that the economy added 850,000 jobs last month—a positive surprise amid consensus expectations for roughly 700,000 new nonfarm payrolls. Characterizing the number as very strong on a historical basis, he noted it was encouraging to see that some of the strongest job gains were in areas of the economy impacted the most by government-mandated lockdowns, such as the leisure, hospitality and dining sectors.

Additional surveys continue to point to strong economic growth globally, Eitelman said, with the J.P.Morgan global manufacturing PMI (purchasing managers’ index) for June coming in at a level of 55. Numbers above 50 indicate expansionary conditions, while numbers below 50 indicate contractionary conditions. Recent data shows that the services sector is rebounding strongly as well, he added.

“All in all, the latest numbers indicate that a very strong economic performance is likely during the second half of 2021 for the globe—and that remains my central expectation,” Eitelman concluded.

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