23 January 2018
Treasury yields have climbed steadily over recent weeks; with the 2-year yield currently sitting just below 2.1% and the 10-year yield hovering a little above 2.6% amid declarations from some prominent investors that the multi-decade bull market in bonds is over (see Chart 2). This column will make no such claims, but we will try to answer how much higher yields might rise over the next 12 months on the basis of how we expect monetary policy to evolve. Our starting point is to consider what is in the price. Assuming that front-end term premia are close to zero, the current 2-year yield appears broadly consistent with the Fed’s median projections. For example, if we factor in five evenly spaced-out rate hikes between now and the end of 2019, the federal funds rate would average 2.01% over the next two years. If the Fed were then to follow through with the two additional rate hikes in 2020, the 2-year yield ought to be close to 2.5% by the end of this year.
However, the fiscal policy, economic and market environment all point to clear upside risks to that 2-year yield outlook. The tax stimulus should be exerting its maximum pressure on inflation during 2019, making it hard for the Fed to decelerate the pace of policy withdrawal. Financial conditions remain highly accommodative; with equity markets reaching new highs, credit spreads grinding lower, market volatility staying low and the trade-weighted dollar continuing to depreciate even as interest rates have risen in the first weeks of the year (see Chart 3). Recent economic data have also been impressive. Industrial output and business investment are both growing at a healthy clip, lifting productivity growth. Wealth gains and elevated consumer sentiment have prevented consumer spending growth from slowing in line with weaker real income growth. And the monthly run rate of core CPI inflation has picked up after last year’s lull. The upshot is that seven rate hikes between now and the end of 2019 is quite plausible, in which case the 2-year yield ought to already be 2.2% and heading towards 2.9% by the end of the year.
Does that also imply that 10-year yields have a lot further to run as well? Here the issues are more complex. Despite the cyclical recovery we have we not revised up our 2.75% estimate for the neutral policy rate. As such, even under the unrealistic assumption that there is no recession, the policy rate would be expected to average only 2.85% over the next decade, and 2.96% in the decade from January 2019. Thus, if US policy rates were the only factor affecting long-end yields, we should be expecting a further flattening in the yield curve this year, with the possibility that it inverts. They are not of course. Long-end term premia are currently very low, partly because of the Fed’s inflated balance sheet, but also because of foreign monetary policy settings and financial regulations that incentivise the holding of government debt. If some of these unwind, term premia ought to rise too. Moreover, looser fiscal policy that forces greater debt issuance at a time when the central bank is absorbing less supply creates additional upside risks. Taken together we expect yields to rise along the curve this year, with the 10-year expected to move into a range between 2.75 and 3.5%, implying some curve flattening, with the extent of that flattening dependent on whether term premia can finally rise back above zero.