Treasury yields nosedived over the past few weeks, falling to the lowest level since February. With the economy growing at the fastest pace in decades, inflation up sharply, job growth soaring, and the Federal Reserve talking about pulling back from its bond buying program, the steep drop in yields has defied conventional wisdom.
It looks to us like the market moves reflect the view that the peaks in growth and inflation in this cycle have passed, and the prospect of tighter policy by the Fed would dampen the outlook for the economy. While we agree with that assessment longer term, we believe yields are now too low relative to the economic outlook and are likely to rebound later this year.
A roller-coaster first half
The contrast between the first and second quarters in the bond market is remarkable. Most fixed income investments were hit hard by the first quarter’s rise in yields as longer-term bonds generally underperformed shorter-term bonds, but those moves were largely reversed in the second quarter. The moves were likely exaggerated by the way investors were positioned.
A tale of two quarters
Source: Bloomberg. See disclosures for a list of the indices used. Data range Q1 2021 (12/31/2020 to 3/31/2021), Q2 2021 (4/1/2021 through 6/30/2021). Past performance is no indication of future returns.
Coming into the year, the consensus expectation was that bond yields (which move inversely to bond prices) would stay low due to concerns that the COVID-19 crisis would keep the economy mired in a recession. However, the reopening of the economy happened much faster than anticipated, aided by strong fiscal stimulus and faster-than-expected vaccine rollout. With demand from cooped-up consumers soaring, supply-chain issues sent prices up sharply, fueling inflation. Consequently, yields surged to 1.74% in the second quarter.
However, in recent weeks there have been signs that the upward momentum in economic growth has begun to slow and inflation pressures have eased. On the global front, the delta variant of the coronavirus is spreading quickly, leading some countries to put new limits on activity.
Domestically, the rate of change in the economic indicators has cooled, although overall levels of activity are still strong. Retail sales, consumer sentiment, and housing activity have declined from high levels, while commodity prices have fallen, and the dollar has firmed up—all signs suggesting the factors pushing up inflation are set to ease. Inflation expectations have been declining. The 5yr/5yr forward breakeven rate peaked in early May at about 2.4%, and has fallen back toward 2%.
Market inflation expectations have been trending lower
Note: This is the 5-year, 5-year USD inflation swap rate. This rate is used by central banks and dealers to measure the market's future inflation expectations. The rate is calculated using the following formula: USD: 2*USSWIT10 Curncy - USSWIT5 Curncy.
Source: Bloomberg. USD Inflation Swap Forward 5Y5Y (FWISUS55 Index). Daily data as of 7/14/2021.
Enter the Federal Reserve
In the middle of the market’s rethinking the outlook for “reflation,” the Federal Reserve indicated it was leaning toward a less-easy policy stance. At the July Federal Open Market Committee (FOMC) meeting, the committee’s median estimates for rates indicated that there might be two rate hikes in 2023, earlier than previously anticipated. In addition, various members of the Fed have been outspoken about wanting to reduce the pace of its bond purchases sooner rather than later and move toward rate hikes as early as this year.
It may seem counterintuitive, but in the past, bond yields have fallen when the Fed has ended quantitative easing (QE). After the initial “taper tantrum” in 2013 sent bond yields higher, they retreated when the actual process began. While tapering, or ending bond purchases, increases the supply that needs to be absorbed by the market, it also is a signal of a step toward tighter policy, which can trigger slower growth and low inflation. The Treasury bond market is very sensitive to these signals from the Fed and responded to the prospect of less-easy policy by sending yields lower. This tendency appears to have been reinforced by the experience of the 2008 financial crisis. The market absorbed the increased supply without a spike in yields.
The 10-year Treasury yield declined after the Fed ended each of its QE programs
Source: Bloomberg, using weekly data as of 7/14/2021. US Generic Govt 10 Yr (USGG10YR Index). Shaded areas represent the periods of quantitative easing. Past performance is no guarantee of future results.
Turning point or correction?
Overall, we believe the market has gotten overextended once again. Ten-year Treasury yields at current levels appear too low relative to the economic outlook. The pace of economic growth and inflation are likely to ease in the second half of the year, but are starting from very high levels and will likely stay above the trends seen in the past decade. The shortage of labor that has emerged from the pandemic will likely mean rising real wages over time. Consequently, demand for goods, services and labor should be healthy enough to support higher yields. Moreover, real yields—adjusted for inflation—are steeply negative and are unlikely to be sustained if the economy continue to make progress. We expect real yields to move up due to a combination of easing inflation expectations and rising nominal yields.
Real yields remain deeply in negative territory
Source: Bloomberg. US Generic Govt TII 10 Yr (USGGT10Y INDEX) and US Generic Govt TII 5 Yr (USGGT05Y INDEX). Daily data as of 7/14/2021. Past performance is no guarantee of future results.
As we see it, the biggest risk to higher yields would be caused by the resurgence of the COVID-19 crisis. The surging delta variant poses a risk to global economic growth if it results in governments curtailing activity to slow the spread. That is a risk we’ll continue to monitor.
Overall we expect the Fed to take a gradual approach to reducing its easy-policy stance, but to still lean toward allowing for more inflation than in past cycles. That should result in somewhat higher bond yields and a renewed trend toward yield-curve steepening. We look for 10-year Treasury yields to trade in a range of about 1.20% to 1.60% over the next few months, with the potential to move higher longer term. We still see the potential for yields to reach 2% later in the year, but it would require another steep rise in yields, similar to the rise in the first quarter. The possibility of that suggests the bond market could be in for some volatile moves in the second half of the year.