Limited upside for bond yields

April 30, 2021 08:48
Market expectations for Fed policy rates have adjusted significantly over the past few months. Photo: Reuters

As we have noted repeatedly, a strong economic rebound and deliberately loose monetary conditions for an extended period of time form the perfect set-up for an increase in inflation expectations in government bond markets. In fact, market-based inflation expectations have recovered strongly since the lows seen last year. US inflation expectations are approaching levels (2.5%) which in the past have proved difficult to surpass, while euro area inflation expectations are still comparatively low and still have a way to go, as the economies reopen over the coming months.

Market expectations for Fed policy rates have adjusted significantly over the past few months. The current implied pace of cumulative rate hikes bears close resemblance to the most recent hiking cycle of 2015 to 2018. The implied path is probably overly smooth as markets tend to price an acceleration in the pace of expected rate hikes once we move closer to a potential lift off in policy rates. While there is still upside risk to our rate view in the medium term, the pricing looks much more adequate after recent moves.

While market-based US inflation expectations are likely close to a top, real rates still look too low given the rate expectations in the US. Consequently, we will have to contend with some upward pressure on real rates in the coming months. However, real rates will likely rise only moderately. Markets will increasingly adjust to the Fed’s new reaction function and will struggle to price a significant amount of additional rate hikes into the rate structure. Moreover, we note that there is a close correlation between the momentum (6-, 12-month changes) in the US ISM manufacturing index and the change in US 10-year yields. Even if the ISM stays above 60 for the next 6- to 12 months, the upward momentum will ease significantly from June onwards. We conclude that the upward pressure on US 10-year yields will likely wane as we enter the second half of 2021.

Unlike in the US, 10-year real yields in the euro area have barely budged in line with unchanged rate expectations. This is unlikely to change in the coming months. With an increase in the pace of vaccinations and a concomitant acceleration in economic growth, markets will likely demand some additional term premiums for holding longer dated euro area bonds. The ECB will likely accept some moderate curve steepening in euro area bond markets along with a further rise in market-based inflation expectations, as long as financing conditions in the euro area do not tighten meaningfully. The ongoing asset purchase programs will be an excellent tool for the ECB to engineer a smooth and moderate increase in bond yields led by the long end.

We reiterate our preference for High Yield (HY) relative to Investment grade (IG) bonds. HY is much less exposed to duration risks and HY companies stand to benefit primarily from an acceleration in global growth.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin