Interest rates have been rising since August 2020, with the yield on the 10-year US Treasury bond having drifted 100 basis points (bps) higher over the past six months or so. But recent rate action has really caught the market’s attention, particularly the 10-year yield’s swift 30 bps increase and the spillover into global equity markets.
Is the latest bout of “rate repricing” due to higher inflation expectations? Stronger economic growth? Treasury supply issues? “Fed fighting”? Let’s try to make 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 spreads between Treasury yields and real (inflation-adjusted) yields, using 10-year Treasury Inflation-Protected Securities (TIPs) as a proxy. Orderly rate moves have been absorbed by risk markets, with equities climbing higher and credit spreads narrowing.
The recent rate rise was different — With the latest yield spike, rather than mounting inflation fears, real yields rose on speculation that the Fed could hike its policy rate sooner than previously thought. Figure 1 shows an inversion of the “breakeven” inflation curve, reflecting higher near-term inflation expectations versus the longer-term ones that formed in February. This is a concern because higher real yields could threaten the economic recovery, whereas higher inflation expectations lower real yields.
The Fed’s playbook hasn’t really 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 Chair Jerome Powell and other Fed officials have reiterated that: 1) rate hikes will not be considered until there has been “substantial further improvement” in the economy; and 2) structural trends like automation, globalization, and demographics have likely suppressed long-term inflation.
Brace for more “Fed fights” ahead — 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 assets 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.
Ten-year yields could go higher — Markets are likely to remain on “inflation watch,” which may induce greater rate volatility and higher yields. 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 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 purchases to help manage long-end rates lower.
For total return, favor short-duration assets. For total-return-seeking bond investors, I suggest limiting fixed income duration exposure, as 10-year yields could rise further still in the coming months.
Higher rates could impact equities. With large-cap growth looking more vulnerable to rising rates, I continue to favor value-oriented, non-US equities; cyclical sectors (e.g., financials, industrials); and smaller caps.
“Bad” inflation prints could spook markets again. Markets are likely to keep reacting to recurring inflation headlines by pushing yields higher, which could be temporarily disruptive to risk assets.
Higher yields often come with an improving economy. Higher yields can bring about a healthy asset-repricing process. While the path may be bumpy at times, I believe today’s environment remains conducive to owning risk assets.