How do U.S. Treasuries pull global asset classes?

Core Viewpoints

We focus on the impact of U.S. Treasury bonds on three groups of assets: U.S. stocks, the U.S. dollar, and foreign government bonds.

The mechanism of U.S. Treasury bonds' impact on U.S. stocks lies in the dividend discount model.

The correlation between U.S. stocks and U.S. Treasury bonds has been mostly negative. Since 2020, the correlation has turned positive, diminishing the safe-haven attribute of U.S. Treasury bonds and the effectiveness of the 60/40 portfolio.

If U.S. Treasury bond yields continue to rise, it may put pressure on the denominator of U.S. stocks.

The mechanism of U.S. Treasury bonds' impact on non-U.S. bonds lies in the term premium.

The term premium explains the linkage between European and American bonds well, as cross-border investments have safety asset allocation requirements and view various government bonds as "substitutes."

If U.S. Treasury bond yields continue to rise, it may still infect European bond yields upward. In contrast, the spillover effect of U.S. Treasury bonds on emerging markets is limited.

The mechanism of U.S. Treasury bonds' impact on the U.S. dollar lies in the "dollar smile" and "fiscal frown" effects.

Due to concerns about fiscal sustainability, foreign investors are reducing their allocation to U.S. assets, and we may still see a combination of high U.S. Treasury bond yields and a relatively weak U.S. dollar at this stage.

Summary

Since the second quarter of this year, U.S. Treasury bond yields have fluctuated at high levels. We analyze the spillover effects of U.S. Treasury bond yields on various global assets, focusing on the transmission mechanisms of U.S. Treasury bond yields on U.S. stocks, non-U.S. sovereign bonds, and the U.S. dollar, as well as historical performance and outlook.

1. U.S. Stocks and U.S. Treasury Bonds: The Correlation Behind Economic and Monetary Effects

We start with the dividend discount model to explain the correlation between U.S. Treasury bonds and U.S. stocks.

The numerator reflects the economic cycle, while the denominator is influenced by the risk-free rate and the equity risk premium (ERP). Expectations of improved economic growth may simultaneously raise the risk-free rate and lower the equity risk premium. Under the joint influence of the numerator and denominator, the correlation between stocks and bonds continues to change.

Since the financial crisis, the world has been in a period of low inflation and great easing, with the stock-bond correlation being negative most of the time.

Since the financial crisis, the global cycle has been primarily demand-driven, and monetary policy responds to fluctuations in demand cycles. As a result, the correlation between U.S. Treasury bonds and U.S. stocks has been negative, with U.S. Treasury bonds serving as a hedge against risk, and classic asset allocation combinations like 60/40 being effective. Consequently, the term premium of U.S. Treasury bonds has also been declining.

Since 2020, the correlation between U.S. stocks and U.S. Treasury bonds has turned positive, with a significant increase in the central tendency, diminishing the effectiveness of U.S. Treasury bonds as a safe haven and the 60/40 portfolio.

(1) The rise in the risk-free rate does not entirely stem from demand improvement; supply-driven inflation has forced the Federal Reserve to raise interest rates to combat inflation.

(2) Due to unsustainable fiscal policies, the term premium of U.S. Treasury bonds has pushed up yields, rather than economic improvement pushing up yields.

(3) Influenced by global asset allocation rebalancing, U.S. stocks and U.S. Treasury bonds exhibit positive correlation.

Conclusion: The current rise in U.S. Treasury bond yields does not equate to a strong U.S. economy. The rise in U.S. Treasury bond yields is more likely to indicate pressure on the denominator of U.S. stocks.

2. U.S. Treasury Bonds and Non-U.S. Bonds: The Term Premium Behind Capital Market Linkage

To clarify the interest rate linkage between countries, we first need to break down government bond yields into two parts: (1) expectations of future short-term rates; (2) term premium We used model decomposition to obtain the term premium and found that compared to expectations of short-term interest rates, the term premium of European and American interest rates is significantly positively correlated.

After the financial crisis, global monetary policy has been highly coordinated. However, the monetary policies of developed countries in Europe and America are not always synchronized, leading to a divergence in market expectations for short-term interest rates in major countries. Nevertheless, the term premium in the bond market tends to converge. This indicates a strong correlation in bond yields among countries, driven by a strong correlation in term premiums.

Why is the bond term premium so highly synchronized among developed economies? The answer lies in the asset allocation demand for cross-border investment.

Thus, the correlation of bond yields between developed countries in Europe and America is significantly stronger than that between U.S. bonds and those of other countries.

After all, the U.S. and the Eurozone account for over 60% of the global cross-border debt investment portfolio, while emerging markets and developing countries account for less than 7%, with many countries representing less than 1%. However, there are signs that Japan and emerging markets are becoming increasingly sensitive to U.S. Treasury bonds.

Conclusion: If U.S. Treasury yields continue to rise, there may still be contagion risks for Eurozone bond rates. In contrast, the spillover effect of U.S. Treasury rates on emerging markets is relatively limited.

III. U.S. Treasuries and the Dollar: "Smile Curve" and "Fiscal Frown"

We describe the correlation between U.S. Treasury yields and the U.S. dollar index through the analysis framework of "Dollar Smile" and "Fiscal Frown."

"Dollar Smile" refers to the tendency for the dollar index to appreciate at both extremes of the U.S. economy, namely during deep recessions and strong expansions, while it tends to weaken during periods of slowing growth.

On the right side of the curve, the dollar index is positively correlated with U.S. Treasury yields, while on the left side, approaching recession, U.S. Treasury yields are negatively correlated with the dollar index.

The "Fiscal Frown" theory posits that the dollar index tends to depreciate when fiscal policy is either too loose or too tight.

When fiscal policy is overly tight and economic growth is weak, U.S. Treasury yields and the dollar index show a positive correlation. During periods of overly loose fiscal policy, the increase in bond supply and concerns about fiscal unsustainability can lead to rising U.S. Treasury yields alongside a depreciating dollar.

In the middle of the curve, appropriate fiscal policy drives economic growth, leading to a tendency for the dollar to appreciate.

Conclusion: Although investors have accepted higher yields as compensation for holding U.S. debt in recent years, concerns about fiscal sustainability have led foreign investors to marginally reduce their allocation to U.S. assets, and we may still see a combination of high U.S. Treasury yields and a relatively weak dollar at this stage.

Main Text

1. (1) The key to the transmission of U.S. Treasuries and U.S. stocks is the economy, monetary policy, and risk appetite.

The correlation between equity assets and bond assets can be studied using the dividend discount model. Economic variables (growth and inflation) and central bank monetary policy simultaneously affect the model's future cash flows and discount rates. For example, a slowdown in economic growth impacts both the numerator (future corporate earnings and dividends) and the denominator (risk-free rate and equity risk premium).

The equity risk premium refers to the portion of stock market returns that exceed the risk-free rate, serving as compensation for investors taking on the volatility risk of the stock market, primarily determined by the macro environment and market risk sentiment According to the dividend discount model,

The denominator discount rate can be further broken down as follows:

The denominator is influenced by both the risk-free rate and the equity risk premium (ERP). Expectations of improved economic growth may simultaneously raise the risk-free rate and lower the equity risk premium. Under the combined influence of the numerator and denominator, the correlation between stocks and bonds is constantly changing.

What we often refer to as "bad news is actually good news" or "good news is just good news" points to the different feedback paths between the economic cycle and the monetary policy cycle, with the correlation between stocks and bonds changing as the main logic of market trading evolves.

(2) Historical Review of the Correlation Changes Between U.S. Treasuries and U.S. Stocks

Since the financial crisis, the world has been in a period of low inflation and great moderation, with the correlation between stocks and bonds being negative for most of the time. U.S. Treasuries can serve as a hedge against risk, and classic asset allocation combinations like 60/40 can also be effective.

During the great moderation period, the economic cycle is often demand-driven, hence stocks and bonds are usually negatively correlated.

In the recession phase, due to weak demand, the inflation rate will be very low, and central banks will strive to lower real interest rates. When risk assets decline, bonds often provide a hedge against risk.

Benefiting from the risk-averse allocation in the asset portfolio, the term premium of U.S. Treasuries turned significantly negative, with the 10-year Treasury term premium dropping to -1% before the COVID-19 pandemic.

In certain phases of the great moderation era, the correlation between stocks and bonds suddenly turned significantly positive, often due to a sudden shift in monetary policy that triggered large fluctuations in interest rates.

For example, during the taper tantrum in May 2013, the real yield on 10-year U.S. Treasuries quickly rose by 100 basis points from -0.3% in May 2013 to 0.7% in July, while the nominal yield on 10-year Treasuries rose by 70 basis points, and the S&P 500 index fell 6% from 1669 points to 1573 points.

Since 2020, the correlation between U.S. stocks and U.S. Treasuries has turned positive, with the central tendency significantly elevated, reducing the effectiveness of U.S. Treasuries as a safe haven and the 60/40 portfolio.

(1) The rise in the risk-free rate does not entirely stem from demand improvement; supply-driven inflation increases have forced the Federal Reserve to raise rates to combat inflation.

(2) Due to unsustainable fiscal policies, the term premium of U.S. Treasuries has pushed up Treasury yields, rather than economic improvement driving yields higher.

(3) Influenced by global asset allocation rebalancing, U.S. stocks and U.S. Treasuries have shown positive correlation.

If these three mechanisms push up U.S. Treasury yields, the impact on U.S. stocks will be negative. We expect that the positive correlation between U.S. Treasuries and U.S. stocks will continue, and any rise in U.S. Treasury yields driven by inflationary pressures and unsustainable fiscal policies may put pressure on U.S. stocks.

2、 (1) First, let's clarify a set of concepts: Term Premium

To explain the reasons for changes in government bond yields, classical economic models decompose government bond yields into two parts:

(1) Expectations of future short-term interest rates; (2) Term premium.

Term premium refers to the additional compensation required by investors for bearing the risk that short-term government bond yields will not change as expected.

Studying the term premium over a long time series can help investors better explain the historical factors driving changes in government bond yields.

Term premium is not the same as term spread.

Taking the 10-year term as an example, the term premium for a 10-year government bond = 10-year government bond yield - the average expected yield of 10-year treasury bills over the next 10 years. Thus, the 10y-2y term spread = the difference in term premiums between 10y and 2y + the difference in expected short-term interest rates during the corresponding period.

Therefore, the term premium cannot be directly inferred from market prices and requires the use of econometric models for estimation.

We use the ACM model to calculate the term premium of U.S. Treasuries and Eurozone bonds and expectations of future short-term interest rates.

First, it is necessary to estimate a complete spot yield curve for each date. The data we can obtain consists of a series of bonds with different maturities, coupon rates, and prices on each trading day.

Second, we transform this into a complete yield curve using the NSS model to estimate the maturity or spot yields for each month.

Finally, to calculate the term premium, we need to further convert the yield to maturity into zero-coupon yields, which can be easily obtained through interpolation and Bootstrap methods to derive the zero-coupon yield curve.

The NSS (Nelson-Siegel-Svensson) model is an extended version of the NS model, which constructs a smooth and continuous yield curve by determining six parameters of the yield curve.

After calculating the six parameters of the NSS model to obtain zero-coupon yields, we can use the ACM model to extract the term premium data.

(2) The Transmission Mechanism of U.S. Treasuries to Non-U.S. Bond Rates

From the disaggregation of Eurozone rates and U.S. Treasury rates, there is a more significant positive correlation between term premiums than between expectations of short-term rates.

Although during specific periods, the expected paths of short-term rates in the U.S. and non-U.S. countries may diverge, for example, since 2010, the expected path of U.S. short-term rates has risen while that of Eurozone short-term rates has declined. However, the term premiums in the bond markets converge, showing a stronger correlation. This indicates that the correlation of bond yields among countries reflects a stronger linkage between their term premiums Why is the bond term premium among developed economies so highly correlated? The answer lies in the asset allocation demand for cross-border investment.

The high correlation of policy interest rate expectations among developed economies is relatively easy to understand, as the global economic cycle generates spillover effects through trade and financial channels, and the U.S. often leads the monetary policy cycle of other economies, with U.S. monetary policy having spillover effects on other regions of the world.

The term premium of sovereign bonds in developed economies shows a higher correlation, with the transmission mechanism being the demand for safe asset allocation in cross-border investment portfolios [1], where sovereign bonds from different countries are viewed as imperfect "substitutes." When the economic outlook for the Eurozone is bleak and sovereign debt yields are suppressed, U.S. Treasuries become relatively more attractive, thereby lowering the term premium of U.S. Treasuries.

The high correlation of bond term premiums among developed economies reflects the close economic and capital linkages between them.

The demand for safe asset allocation in cross-border investment portfolios reflects the high interconnection of capital markets among developed economies. This model applies to bonds of different maturities, including short-term bonds such as 2-year and 5-year bonds, although to a lesser extent.

Looking beyond Europe, the sensitivity of sovereign bond yields in Japan and major emerging market economies to U.S. Treasuries remains limited. However, there are signs that this sensitivity is gradually increasing. The weak auction of Japan's 40-year government bonds pushed up Japanese bond yields, which in turn raised U.S. Treasury yields.

After all, the U.S. and the Eurozone account for over 60% of the global cross-border debt investment portfolio, while emerging markets and developing countries account for less than 7%, with many countries representing less than 1%.

[1] Federal Reserve, Don H. Kim, International Yield Spillovers, 2021.1

(3) A Historical Review of the Linkage Between U.S. Treasuries and Non-U.S. Bonds

Over the past thirty years, long-term interest rates in developed economies have exhibited two characteristics: first, a downward trend in the long-term interest rate center, and second, synchronized high-frequency fluctuations.

Since the early 1990s, the monthly changes in U.S. long-term yields have had an average correlation of about 0.4 with the monthly changes in long-term yields in Germany, Japan, and the UK, reaching levels above 0.7 in recent years.

Even when the Federal Reserve tightened monetary policy from December 2015 to the end of 2018, the 10-year U.S. Treasury yield remained at historically low levels, leading to the 10Y-3M U.S. Treasury yield spread turning negative in May 2019 The performance of U.S. Treasuries may be influenced by the spillover effects of foreign interest rates: the 10-year government bond yields in developed foreign economies such as Germany and Japan are relatively low, making long-term U.S. bonds more attractive in comparison, which depresses the 10Y U.S. Treasury yield due to cross-border asset allocation.

An important piece of evidence is that after the European Central Bank initiated large-scale quantitative easing, we observed a continuous flow of funds from the Eurozone to the United States (Figure 8).

Looking ahead, if U.S. Treasury yields continue to rise, there may still be a contagion risk for Eurozone bond yields. If the fiscal and inflation cycles of developed economies are synchronized, this contagion effect will be more pronounced. However, if the cycles diverge and foreign capital continues to sell off U.S. Treasuries to return to their home markets, it may reduce the correlation between U.S. Treasuries and other sovereign debt yields in the short term, until U.S. Treasury yields rise to a level that is attractive again.

In contrast, the spillover effect of U.S. Treasury yields on emerging market government bond yields will remain relatively limited.

1. U.S. Treasuries and the U.S. Dollar: From "Smile Curve" to "Fiscal Frown"

(1) The Transmission Mechanism of U.S. Treasuries to the U.S. Dollar

Exchange rates are typically relative prices, and the U.S. dollar index is closely related to the relative changes between the U.S. and Europe, as well as the U.S. and Japan.

Since the current Federal Reserve interest rate hike cycle began, the U.S. dollar index has shown a high correlation with the 10-year U.S. Treasury yield, until changes occurred in the second quarter of this year. Recently, the divergence between the two has widened, with fiscal sustainability becoming a new consideration.

We describe the correlation between U.S. Treasury yields and the U.S. dollar index through the analytical framework of "Dollar Smile" and "Fiscal Frown."

"Dollar Smile" refers to the tendency for the U.S. dollar index to appreciate at both extremes of the U.S. economy, namely during deep recessions and strong expansions, while it tends to weaken during periods of slowing growth.

On the right side of the curve, the U.S. dollar index is positively correlated with U.S. Treasury yields, while on the left side, approaching recession, U.S. Treasury yields are negatively correlated with the U.S. dollar index.

The "Fiscal Frown" theory posits that the U.S. dollar index tends to depreciate when fiscal policy is either too loose or too tight.

When fiscal policy is overly tight and economic growth is weak, U.S. Treasury yields and the U.S. dollar index show a positive correlation. During periods of overly loose fiscal policy, the increase in bond supply and concerns about fiscal unsustainability can lead to rising U.S. Treasury yields while the dollar depreciates.

In the middle of the curve, appropriate fiscal policy drives economic growth, leading to a tendency for the dollar to appreciate.

(2) Historical Review of the Transmission of U.S. Treasuries and the U.S. Dollar

Since the financial crisis, the U.S. dollar index has fluctuated and strengthened, experiencing two rapid appreciation phases.

The first wave occurred in 2014 due to the divergence in monetary policies between the U.S. and Europe, as well as Japan, with the European Central Bank initiating large-scale quantitative easing while Japan began "Abenomics."

The second wave of appreciation occurred after the COVID-19 pandemic, influenced by the Federal Reserve's rapid interest rate hikes and the "American exceptionalism" narrative over the past two years There have been two noticeable instances of the negative correlation between the US dollar index and US Treasury yields after the financial crisis, accompanied by a rapid depreciation of the dollar.

In 2017, the global economy experienced a coordinated recovery, and the dollar index depreciated throughout the year, showing a negative correlation with US Treasury yields.

Since the second quarter of this year, the dollar index has depreciated by 6%, completely erasing the gains made since the fourth quarter of last year, and the correlation between the dollar index and US Treasury yields has turned negative.

Although investors have accepted higher yields as adequate compensation for holding US debt in recent years, concerns about fiscal sustainability and weakened demand from foreign investors for US assets may still lead to a combination of high US Treasury yields and a relatively weak dollar at this stage, increasing the cost of US fiscal expansion.

Authors: Zhou Junzhi, Jiang Jiaxiu, Source: CSC Research Macro Team, Original Title: "How Do US Treasuries Drive Global Asset Classes? | JianTou Macro · Zhou Junzhi Team"

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