The current low level of the US 10-year yields is generating a lot of questions. While other bond markets, including sovereign bond markets, have recovered to pre-pandemic levels, US Treasury rates have remained relatively suppressed. To some extent the current level of Treasury rates can be explained by both structural and cyclical factors, as illustrated in an expectations framework that incorporates a lower terminal rate expectation and a more dovish path for short-term rates.
All the same, the US economy is opening up and downside risks are fading. There is renewed economic optimism and inflation breakeven levels are at historically high levels. In this context, the expectation is that the 10-year yields should be slightly higher, especially when we consider the risk/term premia.
In our view, one of the key factors that is limiting the rise of 10-year nominal yields is the level of real yields. If we simplify a bit to focus on the main components, nominal yields consist of a real yield component along with inflation expectations. While breakeven inflation levels have climbed significantly beyond their pre-pandemic levels, real yields are at historically low levels, preventing nominal yields from rising any further (Figure 1).
Figure 1: Real Yields Have Yet to Price in a Reflation Scenario
Low (risk-free) real yields are considered beneficial for risk assets, but real yields in theory should increase with growth expectations. Considering this, in our view, one of two things must be happening: either the market is questioning the sustainability of the current economic recovery, especially in the context of a reduction in policy accommodation, or the monetary policy, specifically asset purchases, is distorting real yield levels.
US Fed on a TIPS Binge
As of June 2021, the US Fed owned a quarter of Treasury Inflation-Protected Securities (TIPS) compared with just 10% in January 2020. The Fed’s purchase of TIPS in response to the COVID-19 pandemic resulted in the first year-on-year net decline in the par value of those securities outstanding in over 15 years (Figure 2).
Figure 2: US Fed Owns a Quarter of the TIPS Market
This means that the TIPS market could be at risk of a taper tantrum style sell-off, especially as the asset class stands out as significantly mis-priced versus the reflation narrative. A significant sell-off in real yields is likely to lead to additional sell-off in TIPS, exacerbating the issue and serving as a catalyst for the underperformance of risk assets.
To some degree the potential rotation out of TIPS and risk assets could be beneficial for US Treasuries, reducing the impact of tapering on nominal yields and narrowing breakeven levels. While 10-year yield levels may receive a lot of attention, real yields stand out as one of the most mis-priced sectors of the investment grade fixed income market.
As such, real yields should serve as the canary in the coal mine for risk assets, including investment-grade credit and equities, where valuations are tight, but fundamentals are improving and there are no catalysts for underperformance on the horizon. These historically low real yield levels are not consistent with the narrative of a robust recovery. This means that somewhere, something will have to give.
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