Investors are becoming concerned as US 10-year Treasury yields are again flirting with 3%, with the concern being that surging yields could precipitate a sharp drop in the value of a variety of asset classes. However, long term yields today reflect subdued – and we think reasonable –expectations about growth and inflation.
There are two scenarios where yields would be expected to rise: a good one, where growth picks up materially, driven by a 1990s-style productivity boom and a bad one, where inflation picks up amid worsening supply-demand imbalance in the Treasury market. In both scenarios, our analysts estimate that the magnitude of the selloff would be small.
There is no universally agreed-upon framework to think about long-term yields. Our approach involves decomposing long-term yields into two embedded components. The first component captures expectations about the path of short term interest rates, which are set by the Federal Reserve. The second component is the term premium, which is the additional compensation that investors demand for taking the interest rate risk of owning longer-term bonds. Our Research analysts see three reasons why any US interest rate increases will likely be small and should not negatively affect global markets in the coming quarters.
Yields today (around 2.7% to 3%) are lower than in the past, but are justified by current modest US growth and anchored inflation expectations.
Treasury yields today are lower than in the past because investors think the Fed will generally keep short term rates at lower levels than they were historically; uncertainty about this outlook is also lower. For example, in the early 1990s, investors expected inflation to persist at elevated levels and also demanded significant compensation for taking inflation risk. Uncertainty was also higher because the Fed’s ‘reaction function’ was less well understood.
By the early to mid-2000s, the Fed had gained credibility in fighting inflation but rates were still much higher than today because the global growth environment then was fairly robust. Current yields reflect relatively subdued expectations about growth, an inflation outlook anchored around the Fed’s 2% target and less uncertainty about the current outlook than previous periods. In other words, there are good reasons for today’s lower level of Treasury yields.
Source: Survey of Professional forecasters, conducted by the Philadelphia Federal Reserve, Barclays Research
The interest rate required to keep the economy in equilibrium has fallen and is unlikely to rise meaningfully.
Growth has recently accelerated; as a result, investors may start to price a steeper path for short-term rates. Yields would rise in this scenario, but our analysts believe the magnitude of the move would not be large. The main reason is that the ‘neutral rate’, meaning the interest rate needed to keep the economy in equilibrium, has fallen and is unlikely to rise meaningfully.
The neutral rate is determined by the balance between supply of savings and demand for borrowing: more supply lowers it, more demand raises it. A higher level of savings in the economy today – driven primarily by an aging population – has pulled down the neutral rate. This is unlikely to change anytime soon, even if growth remains elevated in the near term.
Low levels of uncertainty will help keep investors' required compensation for holding Treasury bonds at subdued levels.
The term premium has fallen over the last few decades because of ‘Great Moderation’, i.e., lower macroeconomic volatility amid stabilizing inflation. We do not believe that this is likely to change soon. However, a handful of outcomes could exert upward pressure on yields. For instance, a sudden pickup in inflation amid an inertial Fed could push the term premium higher.
Alternatively, a worsening supply/demand imbalance in the Treasury market, given higher budget deficits and the Fed’s reduction of its holding of bonds, may also lead investors to demand a greater term premium. However, our analysts argue that given the structural changes to the monetary policy framework, a more than 50bp rise in the term premium is unlikely.
Source: Federal Reserve, Barclays Research