Inflation expectations and US Treasury yields|Li Ruofan
Immediately after the Federal Open Market Committee (FOMC) meeting last week, “dovish” views on the meeting gave market risk appetite a boost and also drove down 10-year US Treasury yields. However, less than 24 hours later, 10-year US Treasury yields rebounded sharply to 1.75 percent, the highest since last January.
In the near future, long-term US Treasury yields may remain the leading factor driving market performance. Because the US Federal Reserve (Fed) has not adopted any measures to interfere with the US Treasury market, long-term Treasury yields will depend on the performance of the economy and inflation expectations. With the rapid roll-out of vaccines in the US and the US$1.9 trillion stimulus plan, few people doubt that the US economy will gradually recover. In fact, expectation of a gradual recovery may already have been digested. In other words, inflation expectations are likely to be the main factor driving up US Treasury yields in the future.
Currently, the US breakeven inflation rate, which reflects inflation expectations, has been continuing to hover at the highest point in years. I believe inflation pressures may intensify in the few months to come. The US$1.9 trillion stimulus plan launched by the US government recently may boost consumption. Meantime, the easing of lockdown measures amid the rapid roll-out of vaccines will also increase consumption. Nonetheless, because of the ongoing pandemic, supply of many services and products may not be able to meet demand in the near future. Some sectors may have difficulties recruiting people. The impact of the low base effect also boosts the probability of rising inflation. With high inflation expectations, yours truly expects long-term US Treasury yields to rise further.
Having said that, why are rising long-term US Treasury yields concerning? For investors, inflation expectations implied by rising long-term US bond yields are the ultimate concern, as that will force the Fed to prematurely raise interest rates. The Fed has two major policy goals: to achieve an average inflation rate of two percent and to attain full employment.
In a section of their latest economic projections in March, four Fed officials said they expect the central bank may need to raise rates in 2022, and the number of officials who expect rate rise by the end of 2023 has increased from five to seven. This change of position may more or less be related to the officials’ outlook on the economy and inflation. After all, the Fed has substantially upgraded expectations for GDP growth and inflation for years 2021 and 2022.
However, at its March meeting, the Fed made it clear that its decisions on interest rates will depend on actual data rather than expectations. It expects the core PCE inflation to come in at 2.2 percent in 2021 and drop to two percent next year. This suggests the Fed does not believe the short-term increase may not last. On the other hand, while long-term bond yields continue to rise, Fed chairman Jerome Powell noted that multiple indicators point to the fact that the overall financial conditions remain loose. This means the Fed is unlikely to switch abruptly to a hawkish policy within a short period of time.
Even so, before we have more data indicating rising inflation is unsustainable, the market may remain relatively volatile because of the differences in views between investors and the Fed on the future trend of inflation. In terms of the foreign exchange market, the relative advantage brought to interest rates by the continuous increase in US Treasury yields may continue to support the US dollar, especially its value against the euro and Japanese yen, which are characterized by low interest rates. Note that the European Central Bank will buy more bonds in the second quarter in order to curb the growth rate of national bond yields. Meanwhile, although the Bank of Japan has decided to allow 10-year bond yields to rise and fall 0.25 per cent each around its zero percent target, the rate remains ultra-low.
As for risk assets, although rising US Treasury yields may cause volatility, especially for technology stocks that are sensitive to interest rates, I do not see that as a sign of a bear market. Rather, it suggests a risk-on mood may prevail in the market. For one thing, the Fed and other central banks may maintain a loose policy, thus creating a low interest rate environment. Besides, the traditional economy may benefit from gradual economic recovery and the easing of lockdown measures. Third, although the real rate of return of 10-year US Treasuries has increased, the rate remains negative, meaning the rate of return of risk assets is still attractive.
(Carie Li Ruofan, economist of OCBC Wing Hang Bank)
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