US yields could gradually rise in bond tug-of-war
Despite rising slightly since the beginning of August, the US 10-year Treasury yield remains well below the peak of 1.74% reached on 31 March. The 10-year yield has primarily been pushed lower by a fall in the 10-year Treasury Inflation-Protected Securities (TIPS) yield (equivalent to the real yield), which remains well anchored in negative territory (at -1.0% on 31 August). Although we are adjusting downward our year-end forecast for the 10-year US Treasury yield from 2.1% to 1.6%, we still expect the 10-year yield to rise from current levels, albeit more gradually than we thought before.
Real yields should rise because we believe US growth will remain robust, despite lingering concerns over the coronavirus. But we do not expect the factors that have pushed TIPS yields down to abate significantly in the coming months—namely fading US growth momentum, the attractive carry offered by TIPS in the face of persistent inflation fears and the Fed’s expanded presence in the TIPS market.
We do not expect a well-telegraphed Fed tapering to have a meaningful impact on the 10-year Treasury yield, nor to make up for the factors supporting TIPS bond prices. However, market participants could be underestimating the chance of rate hikes in the face of robust US economic growth and more persistent inflationary pressures. In the face of persistently higher inflation readings (our US economist expects US core Personal Consumption Expenditures (PCE) to average 2.9% in both 2021 and 2022), inflation expectations could rise again before year’s end. Although we would expect the US Federal Reserve (Fed) to stick to its ‘average inflation targeting’ framework, tolerating higher-than-expected inflation for a while and not rushing into hike rates in 2022, market participants could still begin to fear a Fed policy mistake and challenge its dovishness by pricing a more aggressive rate-hiking cycle, which would send US Treasury yields much higher. We will revisit this risk in more detail in our 2022 scenario. In the meantime, we remain underweight on US Treasuries.