Though higher inflation expectations have lifted yields, the premium investors demand for inflation and interest rate risk isn’t likewise rising. But that could change.
A TD report on the U.S. dollar and markets analyzes rising U.S. yields at the end of 2017.
“After hitting a trough in September 2017, the 10-year yield rose approximately 30 [basis points] ahead of the December Fed meeting,” says the report.
That back-up in yield was largely due to market participants repricing their rate hike expectations after more consistent, hawkish communication from Fed members.
But inflation failed to appear.
As a result, “market-derived metrics of expected future inflation remained low, anchoring longer-dated term premiums,” says the report. “In turn, the yield curve flattened.”
In contrast, last week the U.S. 10-year yield hit a four-year high, driven by inflation expectations, says the TD report, describing the outcome as “sustainable.”
“As the U.S. economy enters excess demand, fuelled further by fiscal policy impacts, inflation expectations should edge up,” says the report.
U.S. term premiums so far aren’t responding to higher inflation expectations, but they should eventually.
“The divergence [of inflation expectations and premiums] should narrow, reflecting fundamentals, especially with the acceleration of the Fed’s balance sheet normalization and greater Treasury issuance to fund government deficits,” says the report. “This may be the primary source of the next leg-up in Treasury yields.”
Outlook for Treasurys
In a January 2018 fixed income report, Paul-André Pinsonnault, senior economist at National Bank, forecasts above-potential GDP growth for the U.S. and accelerating CPI inflation in Q4 2018—to 2.3%.
“This scenario is consistent with three [Fed] rate hikes this year, taking the target Fed funds range to 2.00-2.25% by year-end,” he says—though his outlook depends on inflation’s path in the coming months.
He expects most of the hikes to come in the second half of the year, “when the recent softness of inflation will have proven mostly transitory, providing some tailwinds to long rates.”
The bank forecasts 10-year Treasurys to trade just under 3.0% in Q4.