The yield curve shows how yields for bonds of the same credit rating, typically government bonds, differ based on maturity date. It sounds simple and yet from this curve one can glean insights into market expectations of inflation, economic growth, and future central bank policy. As such, those who follow fixed income markets pay close attention to movements in the curve. In February 2021, the curve’s shape changed by an amount so large in magnitude that a similar shift has not been seen since the 1994 bond market meltdown.
The conventional measure of the ‘steepness’ of the yield curve is the difference between the yields of 10-year and 2-year Government Bonds. In Australia, this gap was 1.04% at the beginning of February. During the month, this gap rose to a high of 1.80%. The driver of this was a sharp increase in yields of 10-year, and other longer duration Australian Government Bonds (AGBs), while yields for 2-year and other shorter duration bonds stayed relatively static. Throughout February yields for 10-year AGBs rose from an initial value of 1.15% to a high of 1.92%. Movements of this size might be common in equity markets, but in the world of government bonds such shifts in recent years have been rarely seen. For context, February 2021 was the Bloomberg AusBond composite index’s worst month since 1994, as surging bond yields throughout the month were mirrored with a corresponding decrease in prices. Not all news is bad however, as a steeper curve allows for additional fixed income investment strategies to be utilised, including those which involve purchasing longer duration bonds and picking up price increases as they “roll down” the yield curve.
This historic shift was caused by a combination of increased inflationary expectations, and a more optimistic outlook of economic growth in the medium term. The component of the increase due to inflation expectations can be tested for directly by comparing the change in yields for 10-year AGBs with the change in yields for 10-year Australian Treasury Indexed Bonds (TIBs), which offer returns that are adjusted in-line with inflation. Throughout February yields for TIBs rose by approximately three quarters as much as for AGBs. This suggests that approximately one quarter of the increase in the yield for AGBs was due to inflation expectations, as, if the entire increase were due to inflation there would have been no movement in the yield for TIBs. The remainder of the increase in AGB yields implies a combination of a more positive economic outlook, and expectations of the Reserve Bank of Australia (RBA) adopting tighter monetary policy sooner than expected. While there is no way to test for either of these, due to; vaccine rollouts, a decreasing unemployment rate, and soaring commodity prices, an optimistic economic outlook is expected post last year’s recession. The first since the early 1990s. The conundrum is RBA policy, as the central bank has moved to directly counter the increase in yields by expanding its quantitative easing program, which involves purchasing 10-year AGBs on the open market. The announcement of this policy led to a dip in yields, but the upwards trend has since resumed. Given the better-than-expected economic recovery to date, the market may have doubts as to the RBA’s conviction in keeping yields low moving forward.
Moving forward, February’s increase in yields could mark the beginning of a return to normal after the COVID induced recession of 2020. While the increase in 10-year AGB yields was extremely large, even after the increase, yields remain low compared to historic norms. The gap between 10-year and 2-year yields remains large however, but this can also be closed from an increase in rates at the lower end of the curve, possibly brought about by the RBA ending its yield curve control program, in which it is targeting yields for 3-year AGBs at 0.1%, the same level as the Cash Rate. The main cause of problems would be in the case that the strong economic conditions that are implied by the increase do not manifest, whether due to a resurgence of COVID, falling commodity prices, or an unrelated reason. If signs of such an occurrence appear it is likely that yields would fall again. Unfortunately, there is no way to be certain of which outcome will occur, but regardless of the specifics of future economic outcomes, February’s events will remain a focal point in discussions of fixed income market outlooks for some time.
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