The Great Yield EXPLOSION

OK, maybe it's not an explosion, but you might have noticed longer-dated yields going up a little this year...

We're seeing a definite bear steepening in the overall curve...

U.S. Yield Curve

Many (including me) were expecting Fed officials to push back against rising yields in case they caused a tightening of financial conditions which would hinder the recovery.

That hasn't been the case.

Financial conditions remain loose...

'No stress in Treasury liquidity amid rising term premia = a happy Fed' - @ZackEisman

The December stress test found that banks suffered more severe losses than under the previous, pre-pandemic test.

But months of building up reserves helped ensure they were positioned to weather the downturn well, with firms building capital reserves in 2020 despite setting aside nearly $100 billion in loan loss reserves.

Fed Vice Chair Clarida stated last week that he was perfectly happy with the recent rise in yields, commenting;

I am not concerned by 10-Year Treasury yield above 1%

Bond yields are still incredibly low.

We would rather focus on why rates are rising than on levels.

So why are they on the up, Rich?  

Is it the reflation trade?

Inflation expectations have certainly increased...

Clarida was very talkative on Friday and had some thoughts on this too...

I expect some inflation above 2% in spring and summer because of calendar effects.

I expect that to be transitory.

I expect inflation to finish the year higher than a year earlier but still below target.

The market seems to be thinking the same.

Inflation is coming.

With the 10 year breakevens at 2.06%, how much higher can inflation expectations reasonably move from here?

I like Chris Weston's (Pepperstone) explanation;

Breakeven rates focus on CPI as opposed to core PCE (personal consumption expenditure) inflation, which of course the Fed set policy by as part of their policy mandate.

However, the general rule is that PCE inflation typically sits around 30bp lower than CPI.

So, if the 10-year breakeven rate rises further to 2.30%, then it is signalling the market sees the Fed meeting its policy objective for average inflation over 2%.

A central bank achieving their inflation goals?

Surely not?

Yields could still push further from here

Bank of America’s Mark Cabana has warned of “upside risks” to the bank’s year-end forecast for 10-year Treasury yields of 1.5%.

He was also on Bloomberg TV yesterday...

 Cabana saying ten year yields move gradually to 1.50 by end of year on @business tv. He’s saying that if they go too quickly, it will show some negative feedback, but if it’s a slow move in yields, they’ll let it roll slowly.— Joe Gilster (@joegilster) January 12, 2021 

JPMorgan Chase & Co. analysts raised their forecast to 1.45% from 1.3%.

Why does this matter?  

  • Yields and inflation expectations have been increasing together

  • Yields could continue increasing throughout the year - strategists expect it, Fed seem happy enough to let this happen

  • Inflation expectations likely have limited upside from current levels

Let's look at how this feeds into real yields.

Remember, 10Y Yield - 10Y Inflation Expectations = Real Yields (the return on bond yields after accounting for inflation)

Real yields are still in negative territory at -0.91%

If inflation expectations top out around current levels but nominal yields continue to rise, this would push real yields higher.

Gold has benefited enormously from negative real rates.

As soon as the Fed emergency rate cut was announced back in March, Gold flipped and rallied from the $1450 area, topping out at $2075 just as real rates printed their low of -1.06%.

Compare these two charts...

10 Year TIPS

Note that I've marked the 'zero' level on the chart as a visual reference rather than an absolute price point.

It should be fairly obvious where this is leading...

Any increase in real yields will be bad news for gold.

Morgan Stanley has also dropped their call for a weaker dollar;

Two key factors are behind the revised call on the dollar. Democrats’ victory in the Georgia runoffs last week suggests as much as $1 trillion in additional Covid-19 relief may be coming as soon as this quarter, the strategists said.

There’s also the possibility of discussions by the Federal Reserve about normalizing policy, which could begin as early as June.

“These two forces have the power to dispel a widespread USD-negative assumption of low U.S. yields,” the firm said. “With focus shifting to new fiscal policies in the U.S., we think both U.S. real yields and the U.S. dollar are in a bottoming process.”

In addition to Morgan Stanley, Wells Fargo Securities strategists wrote on Monday that “USD weakness is starting to look stretched, and we think a short-term reversal is imminent.”

Worth keeping an eye on the U.S. CPI data today (due at 13:30 GMT).

Let's see if the market truly believes that inflation is making a comeback.

L:R Previous, Consensus, TE Forecast