Talking Heads – What's in the mix for yields of US Treasuries?

This is an edited audio transcript of the Talking Heads podcast episode What’s in the mix for yields of US Treasuries?

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast.
Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing recent developments and the near-term outlook for the US Treasury market. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Cedric Scholtes, Head of Sovereigns, Inflation and Rates. Welcome, Cedric, and thanks for joining me.

Cedric Scholtes: Hi, Daniel. Thanks for having me.

DM: Cedric, I think this year has been particularly challenging. We’ve had rates go up and go back down without a long-term trend. More recently, it’s been rates going up. We’ll see how long that lasts. Can you talk about what you see as the reasons for the recent Treasury bond market sell-off?

CS: In the last 18 months or so, it’s been very unclear as to what the general direction would be of the Treasury market So, it did feel the last few weeks as if we were finally getting confirmation that what the US Federal Reserve was looking for, which is a soft landing with inflation coming down without a major rise in unemployment, was coming to bear.  It raises some questions to what’s going on. The first thing to point out is that we have over the last couple of weeks had upside surprises in US growth and employment data and probably slightly stronger inflation data as well. The biggest surprise would have come in early October with the release of the September labour market report in which we had a quite unexpectedly strong number for non-farm payrolls and an unexpected drop in the unemployment rate with also a pickup in the pace of average hourly earnings. That labour market report got people worried that the recent evidence of some softening in the labour market might not be entirely reliable. That might prevent the Fed from continuing on a path of relatively steady rate cuts to about 3%.

The other factor is that with the US election coming up, it’s inevitable that investors will start to position their portfolios for the range of possible outcomes with the emphasis being on the implications for growth, taxes, which has an implication for deficits and therefore the amount of Treasury supply. Those are the primary reasons we’ve seen. The question really is, is it an opportunity to step back into the market and buy Treasuries at these cheaper levels or a warning to be careful because there’s worse to come?

DM: Let me pick up on your comments about the labour market. Can you talk a bit more about [the]

impact, for example, of immigration on labour supply in the US?

CS: There’s been very strong immigration that’s boosted labour supply significantly over the last two or three years. But it’s not the only reason. What we’ve also seen is a steady increase in labour force participation, particularly amongst prime-age workers and especially prime-age women. And that’s probably in part to do with the increasing adoption of work from home, which is making working patterns more flexible for people with families. Both of those elements have led to or permitted the significant increases in the hiring. If employment is increasing, output is also increasing. And of course, those workers spend the fruits of their labour. And so, supply begets its own demand. That’s one of the virtuous aspects of the US growth story over the last couple of years. At the same time, the pace of hiring had generally been coming off in recent months. The surprise in September was that we got a bounce back. Investors are looking at this and saying, well, it looks as if, as if our worries about a soft landing or even a mild recession were overdone.

But I think we have to be cautious. First of all, it’s not many months of data and secondly, there are a lot of complications with the data over the last couple of years because the seasonals are messed-up because of the pandemic. There are reasons to think that some of the decrease in the unemployment rate over September and August is somewhat artificial and essentially [due] to seasonals that that aren’t representative anymore. In in September, there was a very large amount of government hiring, much of which was actually teachers coming back to school for the new school year.  

But there’s also other stuff going on which is more one-off in nature, particularly the growth in protective services workers being hired. That is essentially election workers, people getting hired for security staff and people who are going to be organising the count. That’s going away by December. So, we think that some of the recent labour market strength isn’t really indicative of the trend, it’s really more noise. Some of it is simply to do with the election.

Now where else can we look for evidence of that? Well, you can look at things like the JOLTS survey in which you look at, for example, the hiring rate, and the Quits rate, being a very good indicator of how comfortable people are feeling in their jobs and whether they can find other jobs and therefore able to quit their current occupation for something better. That Quits rate has been steadily falling and continues to do so. So, we think the overall picture is still one in which the labour market is gently rebalancing and getting less tight. And that makes this recent backup and yields potentially interesting as a providing an opportunity to get back in and buy.

DM: What might the reaction of the Treasury market be to the results of the US election? What are some of your thoughts?

CS: So, if we think about the election in terms of themes or policy proposals from the two candidates, we can think about the implications for the bond market.

The first theme is deficits. You have two candidates with quite significantly different fiscal proposals, tax and spending proposals. They’re different in many ways, but they share a commonality in the sense that if either candidate were to win the White House, but also win control of Congress and be able to implement everything that they are proposing, we would have a situation in which the path of deficits, which already, thinking of a long-term basis, looks unsustainable, that path would get worse pretty quickly.

For Donald Trump, if he were to be able to fully implement [his proposals], that would increase deficits over the next decade by between four and seven and a half trillion dollars relative to the baseline forecast. Things are a little better for Kamala Harris, but not that much. We still see an increase of between two and three and a half trillion dollars, respectively. And that is simply the median forecast. Things could actually be worse in both cases. Neither candidate is really proposing to do anything much at all about the path of the national debt or proposing any real fiscal consolidation, which is quite troubling and should give Treasury bond investors pause for thought. It matters obviously, because higher deficits mean higher Treasury supply.

And you have to think about who’s going to take down that supply. Now with Federal Reserve looking to downsize still their holdings of Treasury [bonds], they’re unwinding all their quantitative easing and just letting those bonds roll off. That debt needs to get transferred to the private sector. The question is how much appetite is there to take that supply? And will they do so at the same price as official institutions? The likelihood is no.

Investors will demand increasingly [a] larger term premium, additional yields for the additional supply and for the increase in sovereign credit risk that that comes with it. The likelihood that [at] some point, the Treasury either will not be able to pay its bills or choose to pay its bills via the devalued currency. And so, they’re turning credit risk into inflation risk. The United States has benefited from its exorbitant privileges; essentially, there’s no real alternative to store large amounts of liquidity and money. The JGB {Japanese government bond) market or eurozone sovereign bond markets don’t have the same depth or liquidity. There may come a point at which people say I need to diversify away.

Then you need to think also about the implications for growth of these various proposals. Now, one important aspect is the differences in policy on immigration. Donald Trump is proposing pretty strict immigration controls to limit the growth of the population and essentially to support domestic wages. But limiting the size of immigration reduces the supply of labour for US corporations. It would necessarily tighten the labour market and raise wages and therefore costs for corporations that one would imagine there would be some pass-through into consumer prices, which obviously takes away from any improvements on nominal wages. But it’s important to bear in mind that while Donald Trump makes a lot of noise on immigration, a Harris presidency also would be likely to try and tighten up immigration policy, perhaps in a less severe or less strict fashion. This seems to be an issue where there is bipartisan support.

The next theme to think about is trade. Now this is where there’s really the biggest difference between the candidates. Trump is proposing universal [import] tariffs of 10% or more with targeted tariffs of potentially up to 60% on China. The objective is to close the trade deficit and stimulate a resurgence of jobs back to the United States. So that does suggest that a Trump administration would be keen on raising tariffs until they’re actually impactful. Now their expectation is that tariffs would raise revenues by USD 200 or 300 billion per year. But it’s worth bearing in mind that this is a relatively small sum and isn’t going to be enough to offset income tax cuts that are proposed elsewhere in the budget. Now, most economists will tell you that imposing tariffs is likely to be inflationary, but we don’t know [by] how much. It’s paid by the importing entity. Tariffs can be absorbed either by profits or they can be passed on to the customer.

So, there is an open question about just how inflationary they’re going to be. The broader point to bear in mind when you’re thinking about the big, picture:  inflation is not just the one-off impact on the price level from imposition of tariffs. Tariffs would represent an unwinding of globalisation. It would reduce competition in the domestic market and thereby increase domestic producers’ pricing power and generate a situation where you might just get more background inflation. So, if, the Federal Reserve is trying to hit its 2% inflation target, that’s going to make life a lot more complicated. Those are essentially the themes that we’re looking at when we are thinking about the impact on the Treasury market.

DM: Cedric, if I could summarise some of the key points that you shared with us. When we think about the recent sell-off in Treasuries, you saw surprises in US growth, particularly labour market data, slightly higher inflation data and arguably investors positioning for outcomes of the US election. Now [on] the labour market data, your view [is] that the numbers are distorted and in fact, the labour market is gently softening. Finally, about the US elections, you highlighted at least some of the key things to think about. What would be the impact on deficits depending on the outcome? Would higher deficits lead to higher Treasury yields, impact on growth, particularly if you have greater restrictions on immigration and then tariffs, would higher tariffs necessarily lead to higher inflation? Well, Cedric, thank you very much for joining me.

CS: Thanks for having me.