Interest rates have been rising since August 2020, with the yield on the 10-year US Treasury bond having drifted 100 basis points (bps)1 higher over the past six months or so. But recent rate action has really caught the market’s attention, particularly the 10-year’s swift 30-basis point yield increase and the spillover into global equity markets.
Is this latest bout of “rate repricing” due to higher inflation expectations? Stronger economic growth? Treasury supply concerns? Investors “fighting the Federal Reserve (Fed)”? Or is it those pesky convexity2 hedgers? Let’s take a stab at making sense of it all.
Yields have risen for the right reasons – Rates have been adjusting to prospects for better growth and higher inflation for months now, reflecting an improving pandemic outlook and ample policy support. Rising inflation expectations are baked into wider spreads3 between Treasury yields and real (inflation-adjusted) yields, using 10-year Treasury Inflation-Protected Securities (TIPs)4 as a proxy. Orderly rate moves have historically been absorbed by risk markets, with equities climbing higher and credit spreads narrowing.
The recent rise in rates was different – With the latest spike in yields, real yields are rising not on expectations of increasing inflation but rather on the expectation that the Fed could hike its policy rate sooner than previously thought. FIGURE 1 shows an unusual inversion of the “breakeven” inflation curve, reflecting higher near-term inflation expectations relative to longer-term expectations that formed in February 2021. This is a concern because higher real yields could
snuff out the economic recovery, whereas higher inflation expectations lower real yields.
The Fed’s playbook hasn’t changed – Even though the market has been “fighting the Fed” (i.e., challenging it to meet growing expectations of a sooner-than-anticipated rate hike), Fed Chairman Jerome Powell and other Fed officials reiterated that: 1) rate hikes will not be considered until there has been “substantial further improvement” in the economy; and 2) structural issues such as automation, globalization, and demographics have likely suppressed long-term inflation.
Brace for more “Fed fights” – There could be further yield increases going forward. With economies reopening, higher commodity prices, depressed inventories, supply-chain disruptions, and pockets of skilled-labor shortages, inflation scares could periodically roil the markets. Given that so many risk assets5 have fed off of the prevailing low-rate/high-liquidity regime, I think there are bound to be some drawdowns that cannot withstand higher rates.
10-year yields could go higher – I believe markets could continue to remain on “inflation watch,” which may induce greater rate volatility and higher 10-year yields. If real GDP is 3% and inflation is 2%, and the Fed’s asset purchases are worth -100 to -200bps, a 10-year yield of 2% to 3% is imaginable over the next six to 12 months. However, I think the Fed knows this and views it as a healthy mechanism for resetting growth and inflation expectations to more normal levels, while also wringing out some of the excess in asset prices. The Fed will probably continue to telegraph its rate-hike plans and could even extend its asset-purchase programs to help manage long-end rates lower.