The Fed & rising yields

• This week Federal Reserve Chairman Powell will give his semi-annual testimony to Congress, a timely appearance given the surge in US Treasury yields, breakeven rates and real yields this year.
• Rising inflation expectations and stronger growth prospects have lifted 10Y Treasury yields from 0.90% to 1.39% in 2021, increasing the risk of near-term volatility in equities, credit, commodities and emerging markets.
• But the Fed’s very dovish stance is likely to prevent a major sell-off in US government bonds, thus keeping intact the economy’s recovery from the pandemic and the broad rally in risk assets.

US nominal, breakeven and real yields have all increased sharply this year.

Source: Bank of Singapore, Bloomberg

10Y Treasury yields - nominal interest rates - have risen from 0.90% at the start of 2021 to hit 1.39% this week. Thus, 10Y Treasury yields are not far from our one year forecast of 1.50% as the chart above shows.

10Y breakeven rates - the difference between Treasury yields and Treasury Inflation-Protected Securities (TIPS) and thus a measure of inflation expectations - have also risen to 2.20% this year.

Breakeven rates fell sharply during the pandemic as the next chart shows. But they are now back at levels that signal inflation expectations have returned to the Federal Reserve’s 2% inflation target.

Source: Bank of Singapore, Bloomberg

Last, 10Y real yields - the difference between Treasury yields and breakeven rates (inflation expectations) and thus a measure of economic prospects - are also rising after earlier falling to record lows of -1.08% during the pandemic.

This month 10Y real yields have increased from - 1.00% to -0.80% as the chart below shows, reflecting expectations for stronger US growth.

Source: Bank of Singapore, Bloomberg

The significant recovery in US government bond yields this year is being driven by rising inflation expectations and firmer growth prospects.

The US economy has made a strong start to the year. Commodity prices are rising with copper at 10-year highs of USD9,000 a tonne as the global economy recovers. Inflation rates are likely to temporarily exceed the Fed’s 2% target this year on ‘base effects’ but the central bank isn’t ready yet to start tapering its quantitative easing, and the Biden administration is pushing Congress to approve USD1.9 trillion of further fiscal stimulus.

The sudden surge in US yields this year increases the risk of near-term volatility in financial markets. We see several key implications here.

First, the broad rally seen in risk assets seen over the past year should remain intact as the Fed’s very dovish stance is likely to prevent a major selloff in government bond markets.

Source: Bank of Singapore, Bloomberg

In his testimony to Congress this week, Federal Reserve Chairman Powell is likely to signal again that the central bank will not taper its quantitative easing this year nor consider raising interest rates until after 2023. The chart above shows inflation is still below the Fed’s 2% target and the central bank expects any overshoots of its 2% goal this year are likely to be only temporary as the US labour market remains weak.

Source: Bank of Singapore, Bloomberg

The Fed’s dovishness matters as the threw major bond market sell-offs in the last four decades were all caused by central banks turning hawkish.

In 1987, a surprise interest rate hike by the Bundesbank led to global bond yields rising sharply and the S&P 500 falling by more than 20% in a single day after 10Y Treasury yield increased from 7.00% to 10.50%. In 1994, the Fed suddenly started raising interest rates aggressively at each meeting throughout the year, and, in 2013, the Fed’s announcement that it would begin reducing quantitative easing caused the ‘taper tantrum’ that strongly hurt emerging markets.

In contrast, in 2021, we expect the Fed’s dovish view of inflation and employment to keep 10Y Treasury yields at low historic levels, allowing the broader rally in risk assets to continue despite near-term bouts of volatility.

Source: Bank of Singapore, Bloomberg

Second, further curve steepening may affect corporate bond markets where yield spreads to US Treasuries have already tightened sharply after the worst of the pandemic last year.

In the US Treasury market, the spread between 2Y and 10Y yields has recovered from near zero levels at the start of the pandemic last March to 130bps now as the Fed’s dovishness keeps short end yields anchored while stronger growth prospects steepen long term yields. But the 2s-10s spread has reached 300bps during earlier US recoveries so investors are aware that the Treasury curve can still steepen sharply further.

Third, equities and cyclical commodities like oil and copper should stay supported as rising US real yields reflects stronger growth prospects.

Source: Bank of Singapore, Bloomberg

The last time US real yields swung from deeply negative levels near -1.00% back into positive territory was during the 2013 taper tantrum. The chart above shows stocks, however, were surprisingly resilient as equity investors perceived the Fed’s decision to end its final round of quantitative easing after the 2008 financial crisis as a reflection of improved economic prospects.

Fourth, rising US real yields may present headwinds to precious metals but a weaker USD should still help gold.

The increase in US real yields from negative to positive territory during the 2013 taper tantrum did result in gold selling off as the next chart shows. But the precious metal was also adversely
affected by the USD rebounding.

In 2021, gold has fallen from USD1,950 an ounce to as low as USD1,760. But a weaker USD over time should provide support again to the precious metal this year.

Source: Bank of Singapore, Bloomberg

Fifth, the USD’s downtrend that began last summer has paused this year as US Treasury yields have increased but the Fed’s dovish stance is still set to cause further long-term USD weakness.

The EUR is currently trading around 1.21 against the USD, not far from its three year high of 1.23 hit at the start of 2021 while the GBP reached 1.40 last week for the first time in three years too.

We expect the greenback will weaken further this year - despite higher US yields - as buoyant risk assets reduce demand for the safe-haven USD, the Fed puts off interest rates hikes until after 2023 and the US trade deficit widens as the economy recovers from the pandemic. We thus forecast the EUR, GBP and CNY to rise to 1.30, 1.44 and 6.15 respectively over the next year.

Last, and significantly, the Fed does not appear concerned so far about the sharp rise in US nominal, breakeven and real yields this year.

On Friday, New York Fed President Williams said: ‘we’re seeing signs of rising inflation expectations, back to levels that I think are closer to consistent with our 2% long-run goal, and signs of somewhat higher real yields off in the future, reflecting greater optimism in the economy. So it’s not to me a concern. It’s more of a reflection of the market’s perception of a stronger economic outlook.’ This week, Chairman Powell is likely to repeat the same message to Congress.

We note 10Y Treasury yields at 1.39% are still very low historically and thus continue to benefit risk assets. Only if 10Y yields were to keep surging, for example, by 50bps a month and head towards 2.00% quickly would we expect the Fed to become worried about the impact on the US economy and financial markets more broadly.