The US growth and inflation picture has changed significantly and that’s reflected in the eventful rise in Treasury yields that we’ve already seen this year. We think yields will continue to rise and the 10-year bond yield could potentially increase towards 2.25%.
This anticipation can be attributed to three factors: expectations of where rates could reach this cycle, a potentially higher term premium, as well as the macro picture. Investors aren’t happy owning treasuries at these low yield levels.
The US output gap has closed and the recent unemployment and wage numbers bear that out. This fully justifies the Federal Reserve’s (Fed) aggressive U-turn over the past three months. The central bank is now talking about quantitative tightening going forward, compared with mild tapering previously. ‘Transitory inflation’, the buzzword most of last year, has kicked dust and central banks across the board have had enough of that phrase.
The Fed still thinks that inflation is going to fall from the supply-side angle over the course of this year. But they are gearing up to tackle cyclical inflation pressures, which are on their way up. The market has priced in three Fed hikes for this year, but we think more can potentially happen. We think the market pricing in a peak in Fed rates of around 1.7% is just too low considering the macro changes that we are seeing.
At the beginning of last year growth looked good and inflation wasn’t an issue. But the picture changed as a new variant of the virus kicked in after the summer. Also, the inflation coming through was generally seen as damaging for growth, consumer demand and businesses. That’s why we think the curve flattened and yields were low.
Now, the virus scene is set to get better. Supply-side issues are starting to ease up, which is good for growth. Even if this causes inflation to ease a bit over the course of this year, the Fed can’t relax. Financial conditions over the last year have eased a lot and they’re still very easy, while the market has done little to tighten the conditions. That’s why the Fed has gone into overdrive. But I don’t perceive the market impact from this to be as negative as a lot of people think. The situation is clearly bad for duration, a measure of a bond price’s sensitivity to changes in interest rates, but good for risk markets overall.
The US needs to tighten as growth is looking better across the board. If the virus does ebb it should be a positive for global growth and will help rectify supply chain issues. This scenario should keep the dollar in check. They may also ensure that we don’t see a repeat of 2018 when the dollar rallied as the Fed hiked, even as growth in the rest of the world slumped.
Treasury yields should rise across the board and the front end of the curve – up to 10 years – could potentially steepen. As US yields rise, volatility is going to pick up but I don’t think it will be too aggressive because the cyclical picture does look pretty good.
The European Central Bank should also look to tighten, although China is a wild card. The growth picture is getting a bit more supportive, but we certainly think it is reflected quite heavily in markets already.
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