The decline in US real (inflation-adjusted) yields over the last five months has frustrated many investors who had counted on a rise; instead, yields have touched new lows.
US real yields plunged in 2020 with the imposition of lockdowns across the country and additional quantitative easing from the Federal Reserve, falling below the previous historic low from December 2012 hit during the eurozone debt crisis (see Exhibit 1).
With the discovery of effective coronavirus vaccines late last year, many investors anticipated a sell-off in real yields. This initially occurred, albeit modestly, aided by Democratic victories in Senate elections in Georgia, which raised market expectations for large-scale fiscal stimulus and above-average growth.
What is happening with real yields?
The surprise has been the subsequent rally in yields that took the 10-year yield to new lows, frustrating many investors who had been betting on the opposite.
Yields rebounded by 17bp in August as comparatively high vaccination rates appeared to slow the spread of the Delta coronavirus variant, and the Fed signalled it was moving closer to tapering its monthly USD 120 billion in asset purchases. Yields, however, have remained near the bottom end of the range they have been in since the summer of 2020.
Those investors who believed yields would stay low and held onto their Treasury Inflation-Protected Securities (TIPS) did well over the summer. Monthly inflation data came in much higher than expected, which boosted TIPS prices.
In addition, both real and nominal yields fell on the back of the spreading Delta variant, which paused the economy’s reopening. Nonetheless, we believe there are reasons to expect a move higher in real yields.
Real yields should be higher
Our fair-value model suggests that real yields should be 50 to 60bp above current levels. Two of the key drivers for nominal yields falling over the summer (moderating GDP growth expectations and the Delta wave) should fade (see Exhibit 2).
We expect Covid infection rates to peak in the near future as vaccination rates rise and the wave naturally crests (as has been the pattern in Europe). Several months of economic data coming in below expectations means that it is now more likely that upcoming data will beat forecasts.
The recent statement from Fed chair Jay Powell supported the market’s view that the central bank intends to announce the start of tapering at the November Federal Open Market Committee meeting, with purchases slowing from December through to the summer of 2022.
Tapering purchases should lead to higher yields as the Fed buys less, but the Treasury will also likely be reducing its bond issuance, meaning the net effect on yields could be neutral. An increase in the fed funds rate looks unlikely until the second half of next year. Lacking a strong, short-term monetary impulse, we see only a modest increase in real yields ahead.
Reading the labour market signals
A key driver of taper timing is the speed of recovery in the US labour market. After more than one million jobs were created in July, August disappointed with just 235 000. We nonetheless expect job growth to recover. As exceptional unemployment benefits end and the services sector recovers alongside falling Covid infections, we could yet see strong payroll growth in the months ahead.
Tellingly, 10-year Treasury yields rose slightly on the day of the latest payrolls announcement. This suggests the market believes the drag from the Delta variant on leisure and hospitality jobs will be temporary; at the same time, in August, job growth in industries less affected by Covid was close to previous months.
There is also the view that FOMC policymakers are reluctant to delay the QE taper. The recent increase in Treasury yields may imply that market positioning is now more neutral after having been short real yields (i.e., positioned for yields to rise) over the past few months.
Beyond the stand-alone merits of a short US real yield trade, the position can also act as a hedge for a multi-asset portfolio tilted towards risk, particularly equities. Valuations on US stock markets may be vulnerable to an increase in the discount rate applied to future earnings. A short (real) yield position could help to offset any equity price decline.