What’s behind rising bond yields in Canada and U.S.

Sovereign 10-year bond yields in Canada and the U.S. have risen dramatically over the last month compared to their global peers. At the same time, the yield curve is flattening, and yields for some tenors appear volatile, recent data shows.

For example, after reaching a nearly seven-year high of 3.13% on May 17, the 10-year Treasury dropped back to 2.93% last week.

A TD report reveals the drivers behind these bond market indicators, and says they aren’t signifying a recession—at least for now.

Read: Why rising yields and market volatility are good signs

The report says the return to volatility more broadly since the start of the year typically results in less correlation among global yields, as investors apply a more discerning lens to risks for a particular country. “Importantly, it’s not a bad thing to see, as it ensures complacency does not set and cause market risks to become magnified down the road,” says the report.

In particular, markets have been responding in recent months to inflation, as that has returned to central bank targets in the U.S. and Canada. As TD writes, improvements in inflation “are solidifying the upward path for central bank policy rates and increasing pressure on the term premium.”

The bank adds, “[…] a flat yield curve in the middle of a rate hiking cycle is normal. Over the coming years, we would expect the curve to flatten even further as central banks raise policy rates.” (In contrast, softer data in Europe, for example, “has eased market expectations around rate hike timetables for the European Central Bank and the Bank of England,” says TD.)

With inflation moving higher in North America, investors are demanding a greater premium for locking in to 10-year bonds. “Though still low, this term premium has accounted for nearly three-quarters of the U.S. [Treasury] 10-year’s increase over the last two months,” says TD.

It adds that term premiums should continue to edge higher as rates increase through 2019. “This would translate into 10-year yields moving toward 3.3% in the U.S. and 2.8% in Canada by the end of 2019,” the bank writes.

Since rate hike cycles also correspond to flatter yield curves, it says, “Our clients often ask whether the narrowing spread [between 10-years and two-years] is signalling recession,” says TD. “It is not—at least not yet. Spread narrowing is a very common, and a necessary, facet of a rate hiking cycle.”

There are two reasons for such spread narrowing.

First, explains TD, the forward-looking market typically causes the 10-year yield to make its largest adjustment at the beginning of a rate-hiking cycle, and then grind up more slowly as central banks continue to hike.

Second, shorter tenors that closely reflect the policy path, such as two-year Treasurys, will steadily rise. “The two-year will typically peak when the central bank has stopped raising policy rates,” says TD. “The 10-year/two-year spread will narrow as the two-year catches up to the 10-year.”

For Canada and the U.S., this narrowing of spreads should remain over the next 12 to 18 months, TD adds.

Effect of yield curve flattening

As the yield curve flattens, there’s less margin for error when supply factors enter the equation, causing some “kinks,” says TD.

For example, up until a couple of weeks ago, the Canada 30-year yield relative to the 10-year was separated by only eight basis points. Then, about a week ago, the 30-year yield inverted with that of the 10-year.

This inversion isn’t the sign of a recession, says TD. The bank expects that it likely occurred due to high demand for long-duration assets at a time when supply isn’t keeping up.

“Supply-side factors are at work here, and recession signals generally hail from an inversion of the [10-year/two-year] spread, not just the long end,” says TD. “On that note, the spread remains healthy at around 40-50 basis points, similar to the United States.”

As central banks continue their rate normalization, TD forecasts “the continued flattening of yield spreads and for media headlines to remain fixated on whether warning signals are being flashed.”

It adds that it, too, will be scrutinizing the data: “Yield inversions are indeed good leading indicators of recessions, albeit imperfect.”

For full details, read the TD report.

Also read:

Where to find higher real yields

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