An outlook for U.S. yields

Yields have been on the rise in recent months, presenting a challenge for fixed-income portfolios. Amid a brisk economic recovery and rising inflation expectations, last week the 10-year U.S. Treasury yield reached 1.70%.

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“Since the depths of the pandemic, we’ve seen the 10-year Treasury move higher by about a hundred basis points,” said Samuel Lau, a portfolio manager with Los Angeles–based DoubleLine Capital, in an interview on May 4. “What that means is negative bond performance for our traditional fixed-income portfolios during that period.”

The strong U.S. economic recovery, fuelled by vaccine rollout and fiscal spending, is driving the increase in yields.

“The path of Treasury yields and economic growth usually trend in the same direction, particularly when we go into or are coming out of a recession, which is where we’re at today,”  said Lau, whose firm manages the Renaissance Flexible Yield Fund.

Year-over-year GDP in the U.S. grew by 6.4% in 2021’s first quarter, and future growth forecasts have been revised upward. National Bank expects U.S. growth could be 10% in the second quarter and 6.9% for the year — a performance that will add to the pressure on yields.

“We think that interest rates will continue to rise on [strong economic activity], particularly using the 10-year Treasury nominal yield as an indicator,” Lau said.

He also noted the inorganic nature of the economic recovery, as governments took on massive debt in response to the pandemic.

“The [U.S.] budget deficit today stands at 19% of GDP versus where it was pre-pandemic at 5%,” he said. “That’s a record level.” The previous record for U.S. debt-to-GDP was 10%, set in 2010 during the global financial crisis, he said.

Increased debt means an increased supply of Treasuries, putting upward pressure on yields. Further, the debt was used to provide financial support to U.S. consumers, which has “served to fuel inflation expectations,” Lau said.

He also noted that real yields are increasing, as reflected by the breakeven rate.

“This breakeven rate — the differential between nominal yields and TIPS [Treasury inflation-protected securities] yields — is the market’s expectations for annualized inflation,” Lau said. “This rate has been also on the rise and has probably been the driver of the move higher in nominal yields.”

Other indicators also suggest inflationary pressure. Google searches for inflation have increased, indicating “consumers are worried about inflation,” Lau said, which can be a self-fufilling prophecy.

“If people think prices are going to be higher in the future, they’re more likely to start looking to buy today, which would front-load demand,” he said.

Further, fiscal support could be inflationary, Lau said, though the Federal Reserve maintains that any near-term increase in inflation will likely be transitory.

“It’s kind of like letting the genie out of the bottle,” Lau said, referring to U.S. fiscal spending in the multi-trillions. “You don’t really know what you’re going to get until it’s too late.”

In a report last week, CIBC Economics said U.S. inflation will likely be “stickier above 2%” than the Fed and consensus expect, in part because consumers flush with cash will spend more on services as the economy reopens.

Lau expects the U.S. 10-year Treasury yield could hit 2% by year-end. However, “that trend up is not going to be a straight path,” he said, because the economic recovery could hit some bumps as the pandemic is managed.

“There are going to be ups and downs, but I think the intermediate-term trend is for higher rates on nominal Treasury yields,” he said.

CIBC Economics forecasted the 10-year Treasury yield would reach 1.80% by the end of the third quarter, and 2.00% at year-end. For the first quarter of 2022, National Bank forecasted the U.S. 10-year yield at 2.05%.

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