What's (not) up with long-term yields?
They continue to confound as growth surges and prices accelerate.
Various factors in the economy argue that intermediate and long-term Treasury yields should be rising—strong U.S. vaccination progress, unprecedented fiscal expansion, rapid GDP expansion, headline and core inflation readings at multi-decade highs and rising wages. Yet, the U.S. 10-year Treasury yield remains confined to a narrow range that is well below its March 2021 peak. Why? Several forces have kept a lid on yields: Virus cases, variants and slow vaccination plague various parts of the world; developed country central banks remain highly accommodative, suppressing global rates and attracting capital to U.S. Treasuries; and positioning in the U.S. Treasury market leans heavily short, muting the responsiveness of market yields to stronger-than-expected inflation prints and other strong data.
All that said, the Fed remains the key force repressing market yields, with the policy-setting FOMC continuing to signal 0% target rates and a growing balance sheet for the foreseeable future. But the trajectories of the balance sheet and rate target hinge on other unknowns. Will inflation’s acceleration prove to be transitory, as the Fed insists, and how fast can the healing labor market continue to expand toward maximum employment? It will take a number of months, maybe a couple of quarters, to know for sure. In the meantime, we remain heavily short duration relative to benchmarks in our fixed-income portfolios on expectations Treasury yields will break further upwards this year. Even if the recent inflation spike proves temporary and the return to maximum employment falls short, current nominal and real Treasury yields are still too low by historical standards.
Don’t look for another “taper tantrum”
The Fed has stated it wants to see substantial further progress on its employment and inflation goals before trimming bond purchases. Even amid some disappointment in recent labor-market data, several FOMC participants have begun to talk about the need to discuss taper. As such talk intensifies, expect upward pressure on Treasury yields ahead of an actual taper announcement, likely later this year. Yet, a full-fledged tantrum that sparks a large run-up in yields—as occurred in 2013 after then-Fed Chair Ben Bernanke first uttered the “taper” word—seems unlikely. This time, there is precedent that taper does not signal an imminent increase in policy rates, reinforced by the Fed’s new average-inflation targeting regime that requires PCE inflation to rise above the 2% target to offset many years of having fallen short. In other words, the Fed remains biased to keep target rates near zero to allow the labor market and inflation to run hot for a while.
Some would argue that U.S. recovery and near-term inflation data have been largely priced into the market. That view suggests many market participants have confidence in the Fed’s stance that the inflation surge will be transitory and real rates, which are deeply negative across most of the yield curve, are reasonably valued. We disagree. We think inflation will surprise somewhat to the upside and prove more persistent than Chair Powell expects, driving both nominal and real rates higher. But when and how fast they move remains a waiting game.