6 reasons yields may stay range-bound
It starts with the Fed.
In the nearly six months since the Fed took unprecedented actions to support the economy and markets, Treasury yields have moved little off the historic lows they hit at the height of the Covid economic/financial markets meltdown. Even as the economy has improved and major equity indexes have gone on to hit new highs, cross-currents unleashed by this once-in-a-lifetime event are keeping rates in a relatively tight range—0.50% to 0.80% for the 10-year Treasury and 0.40% to 0.60% for the yield on the Bloomberg Barclays U.S. Treasury Index. Here’s why we expect this dynamic to continue in the near term:
- The Fed Its formal adoption of average inflation targeting and an asymmetric view toward maximum employment further cemented the central bank’s ultra-accommodative stance. Policymakers may go one step further at next week’s meeting, altering quantitative easing to increase long-term bond purchases and/or implementing new forward guidance linking policy-rate or balance-sheet changes specifically to actual inflation. On the other hand, the Fed has also made clear it is not going negative with policy rates, creating a floor that should prevent Treasury yields from going sharply lower.
- Inflation While inflation expectations reflected in Treasury Inflation-Protected Securities have risen from March lows, realized and expected inflation remain below the Fed’s 2% target and have a lot of ground to make up given all the demand destruction and disruptions caused by the pandemic. As long as inflation remains low, Treasury yields will likely do so as well.
- Massive federal borrowing An already high federal deficit has exploded and is forecast to reach $3.3 trillion for the current fiscal year that ends this month. With trillion-dollar deficits expected for years to come, record-sized Treasury borrowing likely prevents yields from going much lower and could eventually put notable upward pressure on yields. To date, however, surging Treasury supply has been met by strong Fed and investor demand.
- The economic recovery Economic growth has bottomed and is now rebounding here and around much of the world. While recent U.S. data has surprised to the upside—Citigroup’s Economic Surprise Index surged late last month to a record high—the improvement is coming off the deepest postwar economic downturn with abundant excess capacity in labor and other markets. The prospect of renewed economic shutdowns seems low, but until there is a vaccine, the tension between full resumption of economic activity and Covid risks will remain.
- Election risk November’s election represents a potential for stark changes in federal policy on many fronts important to the economy and markets (e.g., taxation, trade, environment, minimum wage, and federal spending on infrastructure and social programs). The outcome of such a consequential, binary risk may produce a clear break in price ranges. However, we have a bit less than two months to go and the prospect of a contested election is rising, which could challenge risk asset performance and keep a lid on Treasury yields in the near term.
- Covid is still here While cases have eased a bit in the U.S., particularly in Sun Belt and coastal areas, the pandemic is still a major restraint on many sectors of the economy. As infections have been declining in one area, they have been rising in others, with the rural Midwest the latest hotspot. The two-steps-forward, one-step-back nature of the Covid recovery is now taking shape in schools and colleges. The confluence of the return to school, the flu season and the first Northern Hemisphere fall/winter with Covid circulating may present particular health and economic challenges.