Upward pressure on US real rates ahead
We see bond markets currently in ‘wait and see’ mode as they digest signals from the Federal Reserve and position themselves against the risk that policy makers fall too far behind the curve. Indeed, after a big rise in Q1, US real yields have been range bound for the past two months, with 10-year US Treasury Inflation Protected Securities (TIPS) yielding -1.0% on 15 July. A supply-demand imbalance has kept US real rates negative as foreign investor demand has ballooned while TIPS issuance has remained subpar.
But we are looking towards the Fed’s Jackson Hole gathering at the end of August for signals on the tapering of its USD120 bn in monthly asset purchases. We expect tapering proper to begin by December 2021/January 2022. Encouraged by the more aggressive forecasts contained in the June Fed dot-plot, we believe the tapering announcement will lift suppressed real yields more than nominal ones because the ensuing change in the supply-demand balance will probably be more significant in the TIPS market given its relative shallowness. Any signals that the Fed was contemplating a rate increase before late 2023 could also send real rates higher.
We also expect strong economic fundamentals and the approval of the US infrastructure spending package to put upward pressure on real rates. We are maintaining our year-end -0.1% target for the US 10-year TIPS yield—although we are keeping the option of revising this target depending on the outcome of the Jackson Hole meeting.
Even in the event that our aggressive year-end forecast for TIPS is not reached, we are still of the view that real yields will be the main driving force behind a steady rise in US Treasury yields in 2H21 (although we do not exclude the possibility of a delayed response to the Jackson Hole meeting).
Downside risks to our scenario that would keep real rates anchored deeply in negative territory include an aggressive spread of new variants of the coronavirus, weakening of the Chinese economy and the ongoing risk that disputes over the federal debt ceiling lead to another US government shutdown. On balance, however, we see a strong economy supported by a recovering labour market, tapering announcements from the Fed and congressional approval of the Biden administration’s latest infrastructure package all helping US 10-year real rates become less negative in H2.