With the 10-year US Treasury yield at its highest levels since the taper tantrum, 3% has become a psychologically important number for investors. The recent sell-off has bolstered the confidence of those who believe the market is starting a new bear trend for bonds. However, if the 3 – 3.05% level is rejected and yields trend back down, the retracement would provide serious ammunition to bullish fixed income investors to start pilling back into bonds.
Although 3% is not a magic number, we do view a 10-year yield with a 3% handle as consistent with our macroeconomic outlook for developed markets. Indeed, we think it is not the move towards 3% Treasury yields which is unusual, but the historically low level of yields we’ve seen in recent years, reflecting the long-lasting scars of the financial crisis. The now healthier global economy justifies these higher yields.
We expect the Fed to raise rates three more times this year which would bring front-end yields to 2.375%. We believe that the US economy is strong enough to withstand this gradual once-a-quarter pace of rate hikes. This should allow some steepness in the yield curve to remain between front-end and longer-end yields and indicate the expansion can continue into 2019 as growth and inflation rise together.
Looking first at US growth, fiscal spending (which is expected to generate a fiscal deficit of 804bln dollars according to the CBO in 2018) will be kicking into full gear in the coming months. This should allow GDP to trend around or above 3% in 2018 once we get past the seasonally weak Q1. Since the spending increases will likely not be able to be completely deployed this year, the growth boost will continue into next year.
On the inflation side of the ledger, the leading indicators we follow signal pipeline inflation pressures will continue to feed through to realized consumer inflation in 2018. Over the past several quarters, we have followed the acceleration in price measures within manufacturing surveys, anecdotal reports of labor shortages, and the rise in producer prices as the dollar continues to be on the back foot. Given the magnitude of pipeline price pressure we see in the US economy, we also must consider the possibility that inflation gets to or even exceeds the Fed’s 2% core PCE target this year. The current 6-month annualized run rate for core PCE is already at 2.3%! Given an average core CPI/PCE wedge of ~40 bps (the average since 2015), a 2% read on core PCE would translate to a core CPI rate of 2.4%. This pace of inflation might actually catch some investors by surprise since it would indicate a new cycle high. On the other hand, the Fed’s inflation target is symmetric and they have indicated that gradual rate hikes will remain appropriate even if inflation modestly overshoots.
But all this is arguably what got us to 3% and has also guided our forecast for US Treasury yields to end the year between 3% and 3.5%, driven by the strong US economy and Fed tightening. But what gets us moving sustainably much higher than that, above 3.5% and beyond?
While upside surprises for US inflation will be important, a more compelling case can be made by looking abroad. The very expansionary monetary policy, and correspondingly very low yields, in Japan and the Eurozone has pushed investors in these regions to look abroad in search of higher yields. These capital inflows have in turn helped to hold down US Treasury yields.
The ECB and the Bank of Japan are already reducing their bond purchases, but will not make a decisive shift away from easy policy, including hiking their policy rates out of negative territory, until they see signs of a sustained shift higher in inflation. Growth is eroding economic slack in both regions, but the relationship between traditional measures of economic slack and price pressures has been muddied in recent years for many reasons, including increases in labour market participation and migration. For now, we see only a very modest uptrend in underlying inflation in both the Eurozone and Japan, and the absolute level is still far below target. But the point where inflation and policy rates move higher in the Eurozone and Japan will mark a seismic shift for bond markets.
So what is next? Watch the US 10-year Treasury price action carefully to see if 3.0 – 3.05% area is cleared. This should be accompanied by sturdy US fundamentals and further monetary policy tightening by the Fed. After that, look towards Europe and Japan.