May two (usually) wrongs make a right?

Microeconomists are wrong about specific things – economist and comedian Yoram Bauman often says – whereas macroeconomists are wrong in general. Could it be different this time around? A critical look at both the micro and macro drivers of bond yields suggests that a large part of the move higher, at least in the short term, is likely to be behind us. Central banks will allow rising yields only to the extent that they don’t tighten financial conditions prematurely. In our view, rising yields mostly signal stronger growth – not policy tightening. This is because the upcoming inflation spike should be transitory and so we don’t expect central banks to hike rates over the next two to three years. Of course, bond yields can overshoot. This is certainly possible under extreme assumptions on either the steepness of the yield curve, the pace of increase in real yields accompanying early-cycle recoveries or the sustainable level of bond risk premia. But the extent and duration of any overshoot is likely to be relatively limited under our current economic forecasts.

Yield driver #1 | Policy expectations: The latest Fed projections show that the central bank intends to keep rates unchanged through 2023 and sees the longer-run federal funds rate at 2.5%. By making a few assumptions on monetary policy expectations and the risk premium, we can use this information to come up with a plausible scenario for the trajectory of the federal funds rate and, from it, infer a 10-year Treasury yield path consistent with this scenario. For the sake of argument, imagine that the rate lift-off happens in 2023 (our current forecast) and that the pace of policy tightening is four 25 bps rate hikes per year – more or less the same annual increase, cumulatively, as the last tightening cycle. These assumptions result in a compounded 10-year rate slightly higher than 1.75%.

Yield driver #2 | Risk premium: To go from this to the 10-year Treasury yield, we need to add the term premium – the compensation for interest rate risk. It was consistently negative in 2019-20, which seems rather anomalous. While it has oscillated wildly over the past few decades, its ratio to the level of yields has been fairly stable, at just below one-third. Applying this ratio to our compounded 10-year rate, the ‘fair value’ term premium would be a little over 50 bps which, incidentally, is also the average of the past decade. Combining all this gives us an overall 10-year yield projection of about 2.25%. Of course, there’s considerable uncertainty here, and it’s certainly possible that the term premium rises more markedly. A taper tantrum-style repricing would likely get us to a bit higher than 2.5%.

Here’s why this matters:

What if bond yields overshoot? Of course, investors could take a very different view and keep pushing yields higher. But, if that were to happen, it would be reasonable to assume that central banks will try to do something about it. The Fed may skew its bond purchases towards the long end of the curve in an attempt to push down yields. This is what’s happening in the euro area, where the macro outlook remains fragile: the European Central Bank has recently decided to buy bonds at a faster pace. We doubt that the Fed would allow financial conditions to tighten beyond what they think is warranted. They may have been reluctant to lean against rising bond yields when they were below the lows of the pre-pandemic range. Now that they are above it, while economy isn’t just yet, the threshold for possible interventions – of the verbal kind at first – may have drawn closer.

How should investors think about higher yields? To us, rising bond yields from extremely low levels is a positive sign, not a negative one. This is because it’s happening in the contest of a strong rebound in activity as economies reopen – sooner in the US as the vaccine rollout is faster and fiscal stimulus more substantial, and later in Europe. Historically, rising real rates – especially when coupled with rising inflation expectations – have tended to be associated with better equity and credit performance, as investors come to expect faster growth. We think the upcoming inflation spike in the US is likely to be transitory, and so the Fed is unlikely to tighten in response. The second half of this year will probably see positive, but more moderate inflation trends – at least until the labour market tightens more visibly and/or pipeline price and wage pressures rise to a greater extent.

Meanwhile, the long-awaited inflation spike is coming…

First up, then down: US CPI inflation for March is likely to rise above the Fed target, as base effects kick in. But, stripping out volatile components such as energy and food, core inflation should rise more modestly. The central bank is likely to stay dovish – especially as any inflation overshoot won’t probably last more than a few months. US activity should recover further: industrial production is likely to rebound following weather-related distortions, just like US retail sales – as the latest round of stimulus payments feeds through. China’s GDP, exports, retail sales and industrial production are all likely to show strong growth rates, largely due to easy comparisons with the recession during the pandemic last year. In Europe, despite rising infections and possibly some short-term lockdown extensions, forward-looking indicators such as the ZEW investor expectations should improve further.

Daniele Antonucci | Chief Economist & Macro Strategist