Overnight, a poor auction of 7Y Treasury bonds prompted US yields to spike higher with 10Y Treasury rates hitting 1.60% before retracing.
US Treasury & Real Yields
Source: Bank of Singapore, Bloomberg
10Y Treasury yields have increased by over 40bps in February to exceed our one-year forecast of 1.50%. Similarly, 10Y real yields - nominal 10Y Treasury rates adjusted for inflation expectations - have also surged from -1.00% to -0.60% this month as the chart above shows.
The bond market sell-off is being driven by higher inflation expectations and stronger growth prospects. So far, the Federal Reserve has been tolerant of the rise in yields. This week Chairman Powell said: ‘it's a statement on confidence on the part of markets that we will have a robust and ultimately complete recovery.’
US Treasury & Breakeven Yields
Source: Bank of Singapore, Bloomberg
But central bank officials are set to become more concerned now as tighter financial conditions may hurt the US economic recovery.
Currently, 10Y Treasury yields around 1.50% are still low by historic standards but the Fed will not want to see another 40-50bps monthly rise in yields as occurred in February. Similarly, a sudden 10% decline in equities prompted by surging yields would gain the attention of policymakers. The Fed would also want to see 10Y real yields remain in negative territory to support the recovery rather than returning to positive levels.
In addition, 10Y breakeven rates - a measure of inflation expectations - have started to fall from 2.20% to 2.10% as the chart above shows. This will make officials concerned that rising bond yields will push inflation expectations below the Fed’s 2% inflation target. Last, financial markets are now bringing forward expectations for when the Fed will begin lifting its fed funds interest rate to the start of 2023 - compared to the central bank’s own forecast for no hikes before 2024.
Thus, financial conditions are tightening when officials are still concerned about the recovery. We expect the Fed to stop observing that surging yields are benign - for example by signalling it may delay tapering if bond markets remain volatile. A shift in tone by the Fed would help stop 10Y Treasury yields rising further towards 2.00% in the next few months and instead stay at very low levels still to the benefit of risk assets.
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