Context is key
Recent moves in bond yields make sense with a closer look.
Volatility can be defined as the liability of rapid and unpredictable change, especially when it seems to be happening for adverse reasons. But what has been happening recently in the U.S. Treasury market has not been unpredictable because rising yields make perfect sense within context
Look back to the first quarter. Treasury yields rose sharply over a short period of time, primarily due to increased demand chasing fewer supplied goods, with the former spurred on by enormous federal stimulus and enhanced unemployment payments. That stoked market fears of shortages, rising wages and inflation. GDP growth topped 6% and the unemployment rate fell from 6.7% to 6%.
By the second quarter, markets had recognized the supply chain was unkinking and the yield curve may have gotten ahead of itself. Markets also realized the rise in inflation that emerged in the first quarter was not sustainable. In the face of higher prices, consumers pulled back, deciding to defer purchases rather than pay up for them. Longer-maturity Treasury yields actually fell.
Doldrums is too harsh a word to describe Treasury yield moves during the third quarter, but on balance, yields moved less than 0.10% from second to third quarter-ends. Under the hood, though, yields fell sharply in July, rose slightly in August and then climbed even higher in September. Closer inspection reveals yields rose the most from Sept. 22—the day of the Federal Reserve’s meeting in which it laid out economic projections and all but guaranteed it would start reducing the amount of Treasuries and mortgage-backed securities that it buys. That $120 billion per month purchase program is expected to conclude next summer.
The Fed also indicated conditions are getting closer for it to begin raising the federal funds rate. Some of the unnamed “dot plot” voters indicated the first hike could happen in late 2022, sooner than the market had thought as recently as June. The Fed has stated it does not want to start that process until it concludes the asset purchase program, which also suggests the first hike could take place late next year.
So where does that leave markets? Likely outcomes would be for economic growth to slow from the well-above average pace seen in the first half of 2021, unemployment to continue to fall from its current level of 4.8% and the Fed to begin reducing (tapering in Fed-speak) bond-market purchases after its Nov. 3 meeting. Treasury yields remain well below long-term averages, but nothing demands policymakers must catch up overnight. In fact, recall that the 2-year Treasury yield ranged from 0.20% to 0.60% for more than three years during the early part of the last decade. Given the obstacles the pandemic has produced, it is difficult to envision yields reaching even average levels in the near future.
With cash (and the curve out to about two years) under the Fed’s thumb, it seems unlikely to move until the Fed makes more noise about raising rates. Consistent strong growth and growing inflation expectations would be required to push longer yields appreciably higher. In this environment, we favor shorter duration exposure and underweighting the 5-year point on the yield curve, as it has flexed the most during recent bouts of yield movement.