An Outlook for U.S. Yields

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Sam Lau

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Samuel Lau, DoubleLine Capital, portfolio manager.

Rates have certainly been on the march higher since the pandemic and really since last August. And when I’m looking at the screen today, I see that the 10-year Treasury yield is right around 155 basis points. So, all in all, since the depths of the pandemic, we’ve seen the 10-year Treasury move higher by about a hundred basis points, let’s say. What that means is negative bond performance for our traditional fixed-income portfolios during that period. And in looking at the drivers of that move higher in rates, I would look first to the strength of the economic recovery here in the U.S., as 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.

Now, on the nominal basis, GDP is above its previous high. We have now exceeded the pre-pandemic highs. And it’s a similar type of view when we’re looking at real GDP, which is adjusted by inflation. But either way, it still has been a fast recovery when looking at GDP alone. Real GDP is still about a percent under its previous high, but either way, it just does seem like a very sharp recovery here in the U.S. on the economic activity standpoint.

So, in terms of our forward expectations for 2021 GDP, economists at the start of this year were forecasting a 4% real GDP for the U.S. in 2021, but that outlook has since increased to six and a quarter percent. So, the expectations for economic activity are on the rise as we get more and more data sets that come in.

And thus, we think that interest rates will continue to rise on that — particularly using the 10-year Treasury nominal yield as an indicator there.

So, while the economic recovery has been strong, it wasn’t organic. We have to think back to all the massive debt that was used to get us here. The budget deficit today stands at 19% of GDP versus where it was at pre-pandemic at 5%. So that’s a record level. And just for context, the previous record for deficit to GDP was set back in 2010 during the global financial crisis where it reached 10%, so we’re significantly higher than the previous highs.

So, what that means is an increase of supply of Treasurys, and that increasing supply pressures yields higher as well.

So, on top of that, the debt that was used to fund cheques directly into the U.S consumer pockets was part of the rationale for that debt. So, having the increased cheques going directly in the consumer’s pockets has served to fuel inflation expectations.

So, when we’re thinking about the nominal trader yield and how it rolls a hundred basis points over this period, partly on the economic recovery, but when we dis-aggregate the nominal yield into various components, we can derive what’s called a breakeven rate. And that’s the differential between the nominal yield and the TIPS yield, which is a proxy for what we call real yields. So, this breakeven rate, the differential again between nominal yields and TIPS yields, is the market’s expectations for annualized inflation. This rate has been also on the rise and has probably been the driver of the move higher in nominal yields.

We’re also seeing indications of expectations for inflation to increase based on consumer searches within the Google search engine.

So, consumers are worried about inflation, and this can be a self-fulfilling prophecy as well, because if people think prices are going to be higher in the future, then they’re more likely to start looking to buy today, which would front load demand forward.

I think when we’re thinking about inflation expectations are on the rise, we can look to the extraordinary policies that have been undertaken both by monetary authorities as well as fiscal authorities. And if we’re just focused solely on the U.S., then you’d see that we’ve already allocated over six trillion dollars in fiscal spending toward battling this pandemic over the last year or so. And then we also have an additional four trillion of spending currently being proposed. So, to put this in perspective, the U.S spent under two trillion dollars during the GFC.

So, all of this money that was spent first to support the economy is now transitioning into efforts to stimulate the economy from here. And this has the real potential to be inflationary — that’s not just transitory, as the Fed likes to think. It’s kind of like letting the genie out of the bottle. You don’t really know what you’re going to get until it’s too late.

So, in thinking about the rest of 2021, I think that we do end the year higher on the 10-year Treasury yield. And I wouldn’t be surprised at all if we get close to or even touch 2%.

But that trend up is not going to be a straight path. We will take some detours along the way. While the U.S has shown significant progress in reopening, we could stumble along the way as we continue to navigate our way through this economic recovery and reopening, while simultaneously managing the impact of the pandemic.

So, in addition to the U.S., we of course need to see improvements in the rest of world, which has been very uneven thus far. So, there are going to be ups and downs, but I think the intermediate-term trend is for higher rates on nominal Treasury yields.