U.S. Treasury yields have been pushing higher this week, for reasons discussed below. But does this represent a real shift in market fundamentals, or will further rises be contained? We argue the case for staying close to the status quo.
1. U.S. yields are rising in part due to robust economic data and Fed tightening expectations.
The ongoing sell-off in U.S. Treasuries has been in part due to continued robust U.S. economic data (see page 2), with market now trying to fully price in the likely impact of multiple Fed rate rises in the next 12 months. Aside from the state of the U.S. economy and the Fed’s response, developments on the fiscal front are likely to require increased U.S. Treasury issuance, also bolstering yields, as we discuss below. But current market developments are not just U.S.-driven. The almost-certain ending of European Central Bank (ECB) QE at end-December 2018 (which involves both government and corporate bonds) will in effect take the lid off European yields with implications for transatlantic flows and U.S. yields as well.
2. But much higher U.S. yields would require an increase in inflation or inflation expectations, not yet evident.
Are there any obvious limits on how much further the rise in yields could go? We have a 12-month forecast of 3.25% for U.S. Treasuries and still feel comfortable with this as an anchor. If U.S. inflation expectations are 2.25%, this implies a real return of 1% or so. Treasury yields of above 3.5% would likely put a significant brake on U.S. growth, without a significant upwards move in inflation or inflation expectations. This is not yet evident, although the U.S. labor market is tight. Another factor could also be how the increased U.S. budget deficit is funded: at the moment, this could largely be through shorter maturities, implying further yield curve flattening.
3. Emerging market or other problems could also undermine sentiment, braking yield rises.
As always, sentiment is playing a significant role here. Markets seem less concerned about an imminent U.S. recession and Canada’s accession at the start of this week to the proposed new NAFTA deal between the U.S. and Mexico raised hopes that U.S. trade diplomacy could yield some results. But sentiment can be fickle and markets may not yet fully appreciate the negative implications of higher yields and the multiple risks ahead. Italy could soon be back in the headlines, as could Turkey and Argentina. Many emerging markets with external imbalances remain vulnerable to the double-whammy of higher U.S. rates and higher oil prices and doubts will remain about whether immediate policy responses (e.g. rate rises) can contain the problem. EM problems could hold down U.S. yield rises in the medium term, although short-term moves above our 3.25% anchor cannot be ruled out
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