Mechanisms of rising government bond yields

Fortunately, despite high inflation, US households have healthy balance sheets.

Risk-loss sentiment has bounced back this week and the trigger remains… rising government bond yields! The mechanism of what happens is this: when government bond yields rise, investors turn to capital preservation and reduce exposure to the assets most affected by rising government bond yields. In the credit universe, the first to sell are investment grade corporate bonds, ie bonds with low coupons and long maturities. As the supply of junk credit for sale grows, buyers demand higher risk premiums to own them and spreads widen. Credit rating agencies consider that loans rated investment grade have lower credit risk.

Therefore, the mechanisms make it impossible for investment grade spreads to widen without the most speculative part of the universe, high yield, following suit. Rising government bond yields may also make high-yield investors more concerned about extension risk — the willingness and ability of companies to call their bonds on the first scheduled date — given those companies’ ability to raise capital at a lower yield than the current record coupon of their bonds becomes impossible. Cyclical sectors and hybrid structures are unpopular in this environment. Meanwhile, strategists depress the beasts by declaring that inflation remains high, which is bad news for corporate profit margins, and that low-margin companies should be sold. They argue that the best course of action is for central banks to aggressively raise interest rates to slow the economy and increase unemployment – ​​then the same strategists sell consumer discretionary.

There is a simple solution to stopping the risk momentum: government bond yields must stop rising. This week we had two key events that were not part of the solution. First, at the ECB meeting, President Lagarde announced that the asset purchase program (APP) would end in July and that the ECB would raise interest rates by 25 basis points in July (for the first time in ten years). It is best to keep raising interest rates by 25 basis points per month. So, without an August meeting, there is a chance that rates will rise by 50 basis points in September. According to the ECB’s updated economic forecasts, growth has been revised down and inflation revised up. Inflation is now expected to remain above the ECB’s 2% target throughout the forecast horizon, reaching 2.1% in 2024. Next we had the US Consumer Price Index (CPI) data. Headline inflation picked up and both headline and core inflation beat consensus expectations (CPI yoy 8.6% vs consensus 8.3%, core CPI 6.0% vs 5.9% for consensus). The market’s reaction was to expect another 25 basis point gain over the next 12 months. The withdrawal reactions therefore continue. Fortunately, despite all this inflation, US households have a healthy balance sheet with a $2.4 trillion surplus in savings. We believe this pent-up savings will continue to support growth; We still don’t think the United States will enter a recession in 2022.

Chart of the Week – Inflation rises, but US household savings are $2.4 trillion.

Source: Federal Reserve, Department of Commerce, Goldman Sachs Global Investment Research, May 30, 2022.
Sources: All data from Bloomberg as of June 10, 2022 unless otherwise noted.

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