Fitch decided to downgrade US debt

Say what you will about the timing and justification for Fitch’s decision to downgrade US debt at the start of this month but it seems to have done what it should have done, which is to lift yields. US sovereign debt is deemed riskier as a result of the downgrade and, with treasury yields forming the bedrock of the sovereign and private debt space it is unsurprising that yields have risen.

Of course, the move in yields is pretty modest as befits Fitch’s assertion that AA (the US’s new rating) is still a pretty sound one. But yields are higher and that’s clearly jarring with many investors who have been looking for yields to fall, particularly as the monetary policy cycle goes from one of tightening to easing.

Fitch’s debt downgrade is not the only reason to think that bond yields might be too low right now. Another reason relates to monetary policy and, in particular, the role of prior asset purchases (quantitative easing) by central banks.

Many have argued many times before that the huge quantities of bonds sitting in central bank vaults change the complexion of monetary policy completely by artificially lowering longer-term yields. Of course, central banks don’t agree with this. Those that are tightening monetary policy say that the key instrument is the short-term policy rate and the impact from these huge asset holdings is negligible.

In fact, most focus not on the fact that the stock of these assets is huge, but that the flow is turning as they stop reinvestment of maturing bonds and in some cases conduct outright sales. Hence, they view the issue of their bond holdings as one of trying to avoid an overtightening of monetary policy from reducing assets too quickly.

However, the fact that economies have not slipped into recession, as many feared, or that core inflation has been slow to fall – or still rising in some cases – is testament to the view we take that previous QE has left an almost permanent situation where yields are below the levels that are required to achieve the inflation aims of the central banks. What’s more, it is not just low long-term bond yields resulting from hefty central bank asset purchases that are the problem when it comes to tightening policy.

As we have argued just recently, the counterpart of central bank quantitative easing is the sharp rise in reserves that commercial banks hold at their respective central banks. And with interest now paid on these reserves at (or around) the policy rate, banks are generally seeing good interest earnings. As a result, the robustness of their profits could mean that they are not tightening credit conditions as much as the central banks need to reduce inflation. Of course, some tightening of credit conditions is occurring but the point here is whether it is to the extent required to help bring inflation back to target.

There is another legacy of QE as well that could be frustrating central banks’ attempts to bring inflation back to target and it goes as follows. The sharp rise in asset prices resulting from QE has left household finances in a relatively good position. Household financial assets in the US, for instance are currently around 4 ¼ times the level of GDP, up from around 3 ¼ when QE began. This robustness, together with the fact that longer-term yields have not risen anything like as much as policy rates, means that households have not been as sensitive to tighter monetary policy as they might have been before QE happened.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said putting all this together it does seem to us that a number of factors suggest that bond yields should be higher. But there is a difference between “should” and “will”. For we are not convinced that these arguments will make yields rise much further. For instance, if central banks are frustrated by inflation, they are only likely to push on with more increases in policy rates and this could just as easily lower long-term yields as tighter policy could create expectations of recession and could cause a risk-off rout in asset prices which also benefits bonds. Hence, saying yields should be higher does not mean that they will be.