U.S. Yields’ Trek Higher Seen Getting Fuel From Real Rates

The next leg higher in long-term Treasury yields may come from what’s known as real rates, one of the bond market’s purest reads on the growth outlook.

A burst of strong economic readings -- a mammoth job creation figure Friday and now a report from the Institute for Supply Management showing record growth in service industries -- is fueling bets that expectations for growth, not inflation, will dominate the narrative in Treasuries.

That’s an important distinction because while higher real rates, which strip out inflation, suggest investors see the economic rebound from the pandemic gaining steam, a persistent rise may hurt other assets, including stocks. Relatively risky assets could start to suffer with the market signaling that it sees growth getting so strong that it expects the Federal Reserve to start discussing a tapering of its asset purchases as a step toward tightening policy.

Ten-year U.S. real yields -- as measured by the rate on inflation-linked Treasuries -- are about minus 0.65%, near the highest since mid-2020 and up from a record low of negative 1.12% in September. The last time Fed tapering was in the offing, the real yield flipped from decidedly negative to firmly positive over the year through December 2013 -- when the Fed said it would begin cutting its asset purchases.

“We note the strong March payrolls and ISM readings as early signs of a surge in strong economic data, which when combined with the prospect of further fiscal expenditures, should be sufficient to push yields higher still,” Praveen Korapaty, chief rates strategist at Goldman Sachs Group Inc., wrote in an April 2 note. “However, a smaller inflation pick-up may tilt the composition of any yield increases more heavily towards real yields.”

U.S. Yields’ Trek Higher Seen Getting Fuel From Real Rates

Ten-year nominal yields are about 1.7%, holding below the 1.77% level reached March 30, the highest since January 2020. Korapaty forecasts the 10-year yield will end 2021 at 1.9% and move to 2.1% a year later. Christian Mueller-Glissmann, a portfolio strategist at the bank, told Bloomberg Television on Tuesday it could overshoot to as much as 2.3% in the second quarter.

Most Wall Street strategists say that before lifting rates, the central bank will begin to ponder trimming its bond purchases, a move that’s been a catalyst for higher real rates in the past. Pacific Investment Management Co. said the Fed may begin discussions in June to wind down its asset purchases, while Morgan Stanley predicts it will announce the start of a tapering program in January.

The 10-year real yield moved from about minus 0.6% in January 2013 to positive 0.76% by December 2013.

A surge in inflation expectations has played a big part in driving yields higher in recent months. A bond-market proxy for the pace of U.S. consumer prices over the next decade is at 2.35%, close to a multiyear high.

But the bond market is well aware that while inflation is on course to rise, in the months ahead any notable pickups will be due to base effects, or a comparison to the abnormally low numbers seen last year when the pandemic crushed expectations for growth and price pressures.

The March jobs report is likely to herald the start of even more positive signs on growth, according to Jefferies economists Thomas Simons and Aneta Markowska. While it’s early for the Fed to declare victory on its goals, the strong data should spark the central bank to open the door to tapering discussions, likely at their June meeting -- with an announcement in the final quarter of the year, they say.

Data from other major economies have also been encouraging. Last week, China reported improvements in its industrial, services and construction sectors for March. The International Monetary Fund is due on Tuesday to release its forecasts for the world economy.

What Bloomberg Intelligence Says

“As the outlook for real economic growth strengthens and the Fed signals plans to taper its asset purchases, real yields may continue to be the driver of nominal Treasury yields. An expected reduction in Fed accommodation amid an improving economic outlook could push the 10-year TIPS yield positive before asset purchases start to taper.”

-- Ira. F. Jersey and Angelo Manolatos

The Fed is currently purchasing around $80 billion in Treasuries and $40 billion in mortgage debt a month. More insight into officials’ plans for asset purchases may come Wednesday with the release of the minutes from the central bank’s March gathering.

Some investors aren’t too concerned about the climb in real rates.

If that’s what’s driving the increase in nominal yields, “that’s a positive reason for rates to be moving up,” Karissa McDonough, chief fixed-income strategist at Peoples United Advisors Inc., said in a Bloomberg TV interview. “I think the Fed is happy to see rates increase like this. It’s entirely based on a kind of positive economic outlook.”

©2021 Bloomberg L.P.

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