It’s All About Bond Yields

It’s All About Bond Yields

Thursday, 4 March 2021

There is a whole lot happening in financial markets right now, with the dominating story being the severe sell-off in US Government Bonds. The world’s largest and most important debt market has been met with consistent selling since October 2020 with market conditions said to be the worst in seven years.  All of a sudden no one wants to buy US government debt, with some analysts calling for the end of the 40-year bull market in government bonds (Who would have thought US government debt at 0% return was attractive in the first place?). Within six months we have gone from a market pricing in “QE Forever” and negative interest rates, to one that is becoming petrified of inflation and fearing rate hikes! The fact that markets can swing from one extreme to the other in under six months shows you how fragile the financial system is. But is the world ready for higher interest rates?

A recent auction on seven-year Treasuries saw primary dealers (the big banks that underwrite US bond sales) having to soak up 40% of the sale, the highest in seven years. Liquidity in the bond market is ‘horrifyingly bad’ as there is a general consensus that the US economy will rebound in a big way post COVID vaccinations, and inflation will once again start rising across the broader economy. There are a few questions that should come to mind from all this:

  • Are market participants too optimistic over an economic recovery?
  • At what yield do investors start buying back into bonds?
  • Can the credit bubble survive under higher interest rates?
  • At what point does the Fed step in to prevent yields rising too fast?

US 10 Year Treasury Yield

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The volatility in the bond market has spooked some larger funds, preventing them from otherwise buying, as many may be having flash backs to the liquidity crisis in the bond market that occurred in March 2020. Federal Reserve Governor Lael Brainard said Tuesday “some of those moves and the speed of the moves caught my eye. I would be concerned if I saw disorderly conditions or persistent tightening in financial conditions that could slow progress toward our goals.” So the Fed is certain to step in at some point being the buyer of last resort if needed, but at this stage we don’t know when that is.

The 10Y Bond yield spiked to 1.6% this week before easing back into the 1.4% range. With yields at these levels, it is clearly having an impact on precious metals prices. The higher the current yield on a 10 Year US bond, then less attractive gold is to larger fund managers, as the ‘risk-free’ return on government bonds is the opportunity cost of holding zero yielding gold. But what we’re also seeing is that a lot investors that were brand new to the gold market in 2020 buying up ETFs (read as the ‘weak hands’) are now exiting those positions, some likely at a loss, given the volume of inflows was strongest at the August peak. Gold ETF’s saw a record $47.9 Billion in inflows in 2020, so it would be difficult not to see some sort of correction after such a historic anomaly.

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So those chasing short-term gains from gold during the pandemic have by now probably already left the market. Stronger more long-term physical investors would be the ones buying into this period of weakness in the metals, which is why we are seeing refineries completely out of physical stock for weeks.

Gold doesn’t always have such a tight correlation to what is happening in the bond market, however for the past 12 months this has been the main focus by far, as we have had very few geopolitical events that might otherwise impact prices. We can see in the chart below the sell off in Gold in $USD terms since the peak in August, which so happened to be the bottom in US bond yields.

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We commented in our Gold Outlook for 2021 that ‘what we could see between now and the very early few months of 2021 could be a peak in US treasury yields on the back of a peak in optimism around a COVID-19 vaccine’ and this is what we are seeing today. A fixation in markets pricing in a complete recovery in the US economy, an economic boom and higher inflation. But what most might be missing is that the level of government and corporate debt cannot handle higher interest rates. The last two significant rate hike cycles popped the housing bubble during the GFC and popped the dotcom bubble in 2000, so we doubt this time will be any different if rates are allowed to rise meaningfully.

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With the US government running massive deficits, the higher bond yields are the more the government has to pay in interest on any additional debt they issue. So a greater percentage of tax revenue needs to be used simply to pay the interest on new debt (currently circa $28 Trillion worth for the US). If rates were to normalise the whole game of the past 30 years is over, and the Fed must know this, so they won’t be standing by to let bond yields continue rising indefinitely, unless they want a complete catastrophe. The credit binge that got us to 2021 completely dwarfs that of pre-GFC levels, with just government debt alone standing at close to 130% of GDP. One idea for those looking to pick a bottom in the gold price, pay very close attention to the language coming out of the Federal Reserve over the next few weeks, as gold could reverse sharply higher from the current oversold environment if we get any indication that the Fed is willing to step in and support the bond market.

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Until next week,


John Feeney

Guardian Gold Sydney

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