This year, 10Y US Treasury yields have surged from 0.90% to as high as 1.75%. Bond yields are rising on the back of higher inflation expectations and stronger growth prospects as economies re-open. Central banks’ quantitative easing, near zero interest rates and governments’ large-scale fiscal stimulus are also increasing fears that core inflation will start to increase sharply from current low levels of 1.3%, 1.1%, 0.0% and 0.2% in the US, Eurozone, China and Japan respectively. The level of bond yields is critical for the valuations of risk assets. Over the last few decades, the chart shows 10Y Treasury yields have declined as the Federal Reserve and other major central banks beat double digit inflation rates in the 1980s through high interest rates and then globalization, automation and ageing societies all combined to weaken inflation rates to their current low levels.
In turn, the long-term decline in bond yields has led to risk assets rallying over the last few decades as the chart shows. But whenever the downtrend in 10Y yields appears to have bottomed out, equities have taken fright at the threat of higher borrowing costs in the future.
For example, in 2007 when 10Y yields breached 5.00% before the 2008 financial crisis, the S&P 500 peaked near 1,575. As the chart shows, investors were concerned bond yields were set to reverse their long-term downtrend. Similarly, at the end of 2018 when 10Y yields breached 3.00%, the S&P again fell from 2,900 to around 2,300.
US Treasury Yields
Source: Bank of Singapore, Bloomberg
The fear that Treasury yields were set to reverse their decades-long decline prompted investors to turn risk-averse. This increased demand for safe-haven assets, pushing yields back into their long-term downtrend as the chart shows. Similarly, the Fed stopped hiking interest rates in 2007 and 2018 and instead began to cut its fed funds rate. This also pushed yields down and enabled stocks to resume their long-term rally.
Over the next few months, bond yields are likely to remain volatile as inflation is set to rise above central banks’ 2% targets on ‘base effects.’ Last year as the pandemic began, consumer prices fell sharply in March and April. This year inflation data for the same months is thus likely to show consumer prices being significantly higher than a year ago. Faced with inflation jumping above 2% in the near term, financial markets may become concerned that central banks are allowing inflation to escalate well beyond their 2% targets. But 10Y yields would still need to reach levels around 2.80% before the long-term downtrend in yields would seem to be at risk of reversing.
Instead, we see the Fed keeping interest rates unchanged this year as central banks expect inflation will only temporarily exceed their 2% targets due to still high unemployment. Thus, we think renewed volatility in Treasury yields over the next few months will not cause the long-term downtrend in yields to reverse yet. Our 12-month forecast for 10Y yields is 1.90%, well below the near 3% levels that would mark a potential end to the decades-long decline in Treasury yields.
