Are U.S treasury yields too low relative to inflation?

10-year US treasury yields rose from around 0.9% to 1.4%.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, regards this as a pretty small increase when you consider that PCE inflation has gone from just over 1% a year ago to 5% today. Higher inflation has been accompanied by rapid GDP growth; averaging an annualized 5% in the first three quarters of this year, and the unemployment rate has fallen from 6.7% to 4.2%. This time last year the Fed was forecasting no rate hikes in either 2021 or 2022 but will likely forecast three rate hikes for next year in the previous meeting with more to follow in 2023.

Market-based inflation expectations have risen as well with the 2-year breakeven rate rising from 1.77% to 3.18%. Another point is that we’ve not seen any significant risk-off events this year that might be expected to bolster treasuries and so lower yields. Indeed, the US stock market continues to go from strength to strength with the S&P up nearly 30% so far this year. In short, it seems as if the treasury market has defied gravity, but can it continue in 2022?

Perhaps the first question to ask is, should we have expected yields to rise more given the surge in inflation? The obvious answer might be ‘yes’ but a look at the history of yields and inflation suggests otherwise. It shows that the high inflation period of the 1970’s saw a close relationship between inflation and Treasury yields. Not only did yields rise with inflation in the 1970s, but they fell as inflation declined in the 1980s. However, thereafter the correlation ebbs. Inflation becomes more stable and any inflation spikes don’t seem to lift yields materially. There could be several factors causing this.

One is that investors now have faith that the Fed will keep any spurts in inflation to a minimum. Another, from 2008 at least, has been the influence of quantitative easing as the Fed has bought close to a quarter of outstanding treasury securities and undoubtedly left yields lower than they otherwise would have been. And a third factor is a catch-all “structural trends” explanation that embraces things like foreign demand for Treasuries (the ‘savings glut’ according to former Fed Chair Bernanke), aging populations and more.

If these factors have been important in helping to hold yields down and, if they persist, it is easy to see why higher and even persistent inflation might not lead to significantly higher treasury yields. But, of course, the opposite holds. If these factors wane in their significance, then yields could find themselves much higher. On the first of these – faith in the Fed – the price challenge now is undoubtedly greater than anything we have seen since the 1970s.

So far, the market seems to have kept the faith but Mr. Steve Barrow thinks this could prove tenuous, particularly if the Fed does not suggest a much more aggressive path for policy rates. On the second, QE, he knows that Fed tapering will reduce net purchases to zero next year. That might seem likely to usher in higher yields but much here depends on whether you see QE as a flow concept, meaning that monetary support stops when the flow of new purchases stops. Or whether you see it as a stock issue, meaning that there is still hefty monetary support as long as the Fed holds a stock of treasuries. “We see it as the latter because, in hanging onto a stock of assets, the Fed is still supplying cash to the financial system. This being said, that’s just our view. If the treasury market in general, perceives tapering as policy contraction, then it seems more likely that yields will rise – all else equal. And thirdly, on these structural issues; we do see some grounds for arguing that their ability to keep yields low is waning. For instance, the growth of global trade has stalled and hence surplus countries may have less to recycle into US treasuries. We may find reserve diversification accelerates, especially into the renminbi. While on demographics, the sharp rise expected in the dependency ratio (number of elderly relative to working-age population) could result in more modest savings growth and hence a smaller flow into treasuries. In the end, for all this mitigation, we still lean to the view that treasury yields are too low relative to the inflation threat the Fed faces”, Mr. Steve Barrow said.