U.S. bond yields to rise significantly further

U.S. bond yields to rise significantly further

The doubling of yields on 10-year U.S. Treasury bonds, from 0.7% to above 1.5% since early October 2020 is striking, but it should not come as a surprise (Chart 1). Yields had been severely depressed by the pandemic and were bound to rebound. Even with the increase, yields still remain too low relative to the economic and inflation fundamentals. Inflationary expectations have lifted above 2%, and ex ante real rates remain deeply negative. As the economy reopens and growth shifts into high gear, bond yields are projected to rise significantly further, reflecting a rise in real rates and higher inflationary expectations.

Chart 1

Our official forecast is for 10-year U.S. Treasury bond yields to increase to 2% by year-end 2021, but the risks are to the upside, based on our projection of robust economic growth (Strong U.S. growth, inflation, and the Fed’s challenges, February 11, 2021). Remember, just several months before the pandemic unfolded, bond yields were 1.9%. Earlier, in September 2018, following a period of healthy growth and just before the Fed began to signal that it would not raise rates any further, yields exceeded 3%.

Certainly, the Federal Reserve’s massive purchase of Treasuries (a total of $2.4 trillion in 2020 and a current monthly rate of $80 billion) and mortgage-backed securities ($631 billion in 2020 and a current monthly rate of $40 billion) has kept bond yields lower than they would be otherwise. Bond yields will rise further despite these purchases.

Such a recovery in bond yields as the economy recovers would be a natural adjustment. In fact, it would be unnatural if bond yields did not adjust. Too many market participants think the Fed can keep a lid on bond yields. The Fed administers short-term rates and can temporarily influence bond yields, but it is a misperception that the Fed can “manage” bond yields on a sustained basis.

Suggestions that the Fed increase its QE (or introduce yield curve control, YCC) to keep bond yields low are misguided. Doing so would add fuel to a strong economy driven by already massive fiscal and monetary stimulus, and mounting inflation concerns, and could backfire badly on the Fed’s credibility. One possibility would be for the Fed to announce that it will take steps to extend the duration of its portfolio - by buying long duration securities (Treasuries and MBS) and letting short duration securities mature. This would temporarily reduce bond yields, but probably not for long if economic growth is strong.

Inflationary expectations, real rates and market behavior. Since the earlier historically low bond yields associated with the pandemic, both inflationary expectations and real rates have risen. Inflationary expectations are unobservable, but a common measure is the break evens on TIPs (Chart 2). However, this measure may overstate inflationary expectations because the Fed has been a significant purchaser of TIPs, pushing their yields further negative ‑- and lifting the break evens (Chart 3). Survey-based measures of inflation expectations have risen by less but remain above 2% ‑- but such surveys are not particularly reliable.

Chart 2

Chart 3

Based on a blend of market-based and surveys of inflationary expectations, real rates remain deeply negative. Such negative real rates are unlikely to be sustained if the widening distribution of the vaccines allows the economy to reopen and the real economy rebounds strongly. With all of the fiscal and monetary stimulus in the pipeline ‑- and more to come ‑- robust real growth appears to be on the horizon.

It has been reported that convexity hedging ‑- which involves holders of mortgage portfolios selling Treasury bonds to hedge against rising duration in their portfolios as mortgage pay-downs slow in response to rising bond yields ‑- has contributed to the rapid increase in yields. Convexity hedging has definitely accelerated the rise in Treasury yields and has added volatility. But, it is important to put its impact into perspective: Treasury yields were too low, and they had to rise at some point…and the fundamentals suggest that eventually they will reach much higher levels.

The yield curve. The yield curve has steepened significantly, as bond yields have soared while yields on short duration securities have been anchored by the Fed’s zero interest rate policy (Chart 4). A steep yield curve is a classical signal of easy monetary policy. The longer the Fed maintains its current ultra-easy policy, the curve will remain steep and history suggests significant further room to steepen. Eventually the curve will flatten ‑- as the Fed raises rates ‑- but that seems a long ways off.

Chart 4

Looking forward, short-term yields may increase as markets raise their expectations of eventual rate hikes. Recently, the Fed funds futures markets have begun to price in earlier Fed rate increases. In all certainty, the Fed will significantly raise its economic growth and inflation forecasts in its updated Summary of Economic Projections (SEPs) that will be released following its March FOMC meeting, and very likely will project that it is appropriate to raise rates in 2023 (Strong U.S. growth, inflation, and the Fed’s challenges, February 11, 2021). No doubt financial market expectations will be ahead of the Fed. It all adds up to higher rates.

Global demand for U.S. Treasuries. Yields on U.S. Treasury bonds remain far above yields on liquid and the low-risk sovereign bonds of Germany, Switzerland, the UK and Japan. However, the attractiveness of U.S. Treasury bonds is tempered by inflationary expectations, which are rising faster in the U.S. than other major advanced nations, and expectations that the U.S. dollar may weaken further. The Fed’s aggressive QE and forward guidance of sustained ultra-easy policy, and massive deficit spending on the fiscal side, may add downward pressures to the U.S. dollar (The U.S. dollar to fall further, August 6, 2020).

Global portfolio managers must incorporate currency and inflationary expectations into their expected rates of return and risk of holding U.S. government bonds. Several dominant themes in the current public debate ‑- the Biden Administration and Congress emphasizing that massive increases in government deficits and debt are not a concern, and the Fed’s sanguine outlook for inflation and impression that sustaining its monetary policies involve little risk ‑- add risk and uncertainty to the calculation.

Mickey Levy, mickey.levy@berenberg-us.com

Member FINRA & SIPC
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