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Long-term U.S. bond yields jumped from April lows as policy developments, like the budget bill, draw focus to U.S. debt sustainability. This has revived questions about the diversification role of Treasuries. We have long pointed to the low, even negative, risk premium investors accepted for Treasuries – and expected it to change. That’s now playing out, dragging up developed market government bond yields. We stay underweight long-term bonds but prefer the euro area to the U.S.
Ultra-low interest rates in the pandemic lulled investors into a sense of safety about ballooning government debt. They accepted lower term premium, or compensation for the risk of holding that debt over a long time. That pulled down global yields as well (see the chart below). But long-term yields are up sharply since April as investors demand more term premium. We have long expected that.
In 2021, we flagged that elevated government debt created a fragile equilibrium, with bonds vulnerable to changing investor perception of their risk. And we pointed to persistent inflation pressure from post-pandemic supply disruptions. Higher inflation, and thus higher policy rates along with any rise in term premium, boost debt servicing costs. We’re still underweight long-term developed market (DM) government bonds, but have a relative preference for the euro area and Japan over the U.S.
Our strongest conviction has been staying underweight long-term U.S. Treasuries. We maintain that view as concerns about the deficit mount. In March, we estimated the U.S. deficit-to-GDP ratio would land in the 5% to 7% range, based on external forecasts of the impact of proposed trade, fiscal, and immigration policy. Since then, Moody’s cut the U.S. top-notch credit rating, and Congress is considering a budget bill that we think could push deficits to the upper end of that range – or beyond. We’re watching to see if these changes impact foreign investors and drive term premium even higher.
In Japan, 30-year bond yields hit a record high in May, confirming our long-standing underweight. Japan’s central bank – historically the largest government bond buyer as part of policy easing to lift the economy out of deflation – has trimmed purchases as part of its policy normalization. That has put pressure on long-term yields, and a recent long-term bond auction drew the weakest demand in a decade. This in turn prompted Japan’s Ministry of Finance to consider trimming long-term bond sales. If yields rise more, the government’s cost to service its debt – now twice the size of its economy – will also rise.
The U.K. is already rolling back long-term bond issuance amid lower demand and higher yields. Meanwhile, euro area yields have been rising as governments up defense and infrastructure investment. Yet we prefer euro area government bonds to the U.S. They’re increasingly less correlated to fluctuations in U.S. Treasuries, and a sluggish economy gives the European Central Bank more room to cut rates in the near term. For income, we prefer shorter-term government bonds and European credit – both investment grade and high-yield – over the U.S. on cheaper valuations.
On equities, we flipped back to being pro-risk in April once it became clear that hard economic rules limit how far U.S. policy can move from the status quo, such as how foreign investors fund U.S. debt. Our U.S. equity overweight relies on that rule, just as another rule – supply chains can’t rewire overnight without serious disruption – proved binding on trade policy. This overweight is grounded in the artificial intelligence mega force – reinforced by Nvidia’s recent earnings beat.
U.S. Treasury yields have jumped since April. That’s a global story of normalizing term premium. We stay underweight long-term DM government bonds, preferring shorter-term bonds and euro area credit.
Jean Boivin is Managing Director, Head of the BlackRock Investment Institute at BlackRock Inc.
Wei Li is Global Chief Investment Strategist, Blackrock Investment Institute at BlackRock Inc.
Glenn Purves, Global Head of Macro – BlackRock Investment Institute, and Michel Dilmanian, Portfolio Strategist – BlackRock Investment Institute, contributed to this article.
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