The yields on 10-year Treasury securities finally moved above 1% in January after 10 months of a public health crisis and economic distress.
We expect the 10-year yield to rise to 1.75% by the end of the year.
Though real (inflation-adjusted) interest rates remain negative – or nearly so – along the yield curve from overnight rates out to 10-year securities, there are nascent signs of economic recovery and of confidence in the ability of the monetary and fiscal authorities to invest in that growth.
We now expect the 10-year yield to rise to 1.75% by the end of the year, with risk of a move at or above 2% on the back of what we expect to be the best year of growth since 1984. That growth will be fueled by consumer spending and a renaissance in fixed business investment in software, equipment and intellectual capital.
The following charts show increased confidence in the economy and less risk of corporate default, less risk of state and local default, and stable levels of inflation expectations.
High-yield corporate spreads
High-yield spreads have moved below trend, signaling increased confidence in an economic recovery and less risk of corporate default among the riskiest of corporate bonds. While the recent backup in yields has garnered the attention of investors and policymakers, rates at these levels are inherently supportive of the corporate sector and economic recovery and expansion.
Municipal bond spreads
Muni spreads have moved below trend, signaling increased confidence in federal assistance and the prospect of improved revenues as the pandemic is contained. Given the broad assistance for states and localities in the Biden administration’s American Rescue Plan, conditions are favorable for a recovery in state and local finance this year.
Expectations of short-term interest rates and term risk
The term premium – which is the compensation investors require for holding long-term securities rather than a series of short-term money-market securities whose return is guaranteed – turned positive in February. This is a positive development that translates into diminished expectations of event risk and the threat of deflation.
Notable examples of event risk run anywhere from the 1970s oil embargoes to policy errors like the 2018-20 U.S. trade war to the pandemic.
The arrival of the vaccine and the prospect of its worldwide distribution, the reestablishment of international relationships, and the potential of the reopening of commerce have all worked to push the term premium back into normal ranges.
At the same time, guidance from the world’s central banks is that short-term interest rates will be kept at a minimum until economic growth is sustainable, and that bank purchases will continue to moderate increases in long-term interest rates.
Inflation expectations, actual inflation and 10-year yields
Inflation expectations in 10 years – as measured by the Philadelphia Fed – remain at just over 2%, which is not coincidentally the long-term target of Federal Reserve policy.
Long-term interest rates have been in worldwide decline since the central bank adopted inflation-targeting regimes, and then when technological developments brought about the global supply chain and a global supply of labor. We expect those supply chains that faced constraints early in the global economic recovery to move back to full capacity over the next 12 to 18 months and the inflation risk built into rates to ease by the end of next year.
The Fed has consistently lowered its overnight policy rate when a crisis has pushed the economy into recession, and then raised interest rates when sustainable economic growth can support whatever rate of interest is normal for each particular era.
We do not anticipate that the Fed will begin to taper its $120 billion in asset purchases until early next year, and then that tapering will take the better part of 24 months to complete given the size and scale of Fed monetary accommodation. This supports the Fed’s forecast of no increase in the policy rate, which stands at zero, until late 2023 or early 2024.
The Fed’s ability to guide market sentiment has reduced the volatility of the business cycle in other eras, though as recent experience has shown, investors will from time to time challenge the Fed’s intent to follow through on current policy given the rapid improvement in the economic outlook.
The need for normal rates of return on investment
The secular decline in long-term interest rates and the advent of lower-for-longer short-term rates just might be responsible for the asset valuations in recent years. Notably, the amount of cash sloshing around the global economy before the 2007-09 financial crisis is thought to have been a factor in the undoing of financial stability. And in the years since, with so low a return in fixed-income securities, the equity market has become the only game in town.
This speaks to the risk of not being aggressive enough in reviving an economy that has had to weather a global manufacturing recession followed by the shock of a global pandemic to normal levels of commerce.
Demand for U.S. Treasury securities
The demand for U.S. Treasury securities – as measured by auction bid-to-cover ratios – has been in decline since 2010. We can attribute the decline in bid-to-cover ratios to the low rate of return of fixed-income securities and the unwinding of quantitative easing as the economy moved from recovery to stability. Nevertheless, the auctions remain successful and domestic demand for U.S.-issued paper remains solid.
Foreign demand for U.S. Treasury securities
Foreign purchases of U.S. Treasury securities have a role in pressuring U.S. yields lower in complement to the dollar’s role in facilitating global commerce. Exporters to the U.S. have traditionally parked their receipts in the safe-haven of U.S. securities. And as our analysis shows, foreign demand for U.S. Treasury securities plummeted last year during the pandemic and global economic shutdown.
An increase in U.S. imports is both a sign that the U.S. economy is recovering and that our trading partners can join in that growth. And if that indirectly helps keep U.S. yields lower and helps reduce the cost of U.S. investment, then it’s a win-win situation. While yields remain historically low, the recent backup in rates should bolster global demand and put a floor under the value of the U.S. dollar.
The real rate of interest and an opportunity to invest
Theory suggests that investors require a real rate of return on their investment plus compensation for inflation. Under that theory, subtracting the rate of inflation from nominal interest rates equals the real, or inflation-adjusted, interest rate.
Our analysis shows that the real 10-year interest rates have finally moved above zero when Treasury yields move above 1.5% in latest trading. This corresponds to the long-term decline in the natural rate of interest estimated by economists of the Federal Reserve system.
Negative or near-zero real 10-year interest rates create the opportunity to finance support for damaged income streams and to invest in the continued growth of the economy.
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