Will a slide in US bond yields extent much further?

The 10-year treasury yields could be over 2% in the next year, or so.

As we have noted over the page, our working assumption relating to the new Omicron variant of coronavirus is that it will not materially increase mortality. On the contrary, it might serve to show that new variants, while more transmissible, are ultimately less potent. If so, that puts the world closer to the end of this crisis and not closer to the beginning. Of course, there will still be an adverse impact as policymakers maintain restrictions and, in some cases increase them. But even this seems more likely to lift yields over time if it adds to the supply-side pressures that have already pushed inflation up materially. This week’s US CPI data for November is expected to result in another big 0.7% monthly increase; this time taking annual inflation up to around 6.7% from 6.20% last time.

Of course, many will claim that annual inflation is quite close to a peak now, if only because of base effects but, as we have argued all along, what’s happened is that inflation has broadened out. For what started off as isolated pockets of inflation in certain supply-challenged areas, such as autos, is now a broader problem as areas that were quite sedate at the start have now started to rise, like the important housingrelated components. You no longer hear Fed Chair Powell dismiss inflation as being in a few distinct sectors, just as he no longer says that it is transitory. The sad fact for the Fed is that it geared its policy in the 2020 review in a way that assumed inflation was defeated, only to find that it has come back stronger than ever.

As a result, it not only faces higher inflation but also a framework that does not lend itself to its quick elimination. In our view, eliminating inflation will require monetary policy to become restrictive but if you listen to Fed members, many don’t even see the Fed funds rate getting back to its definition of ‘neutral’ which it currently puts at 2.5%. Worse still in our view is that the market sees rates even lower than the Fed and hence much lower than the neutral rate. The Fed took the Fed funds target up to the 2.5% ‘neutral’ rate in the last cycle and, back then the Fed was not even trying to tackle an inflation problem.

During the whole 2015-2018 tightening cycle annual CPI inflation never rose above 3% and at the time of the last hike was only just over 1.5%. Admittedly, there was some talk at the time that the Fed had overtightened, not least by former President Trump. But while there might have been some truth to such accusations, we still find it hard to believe that the upcoming rate cycle from the Fed will see policy and market rates peak as much as 100-bps below the peak of the previous rate cycle. No doubt some of the argument for a lower peak is that governments, not just in the US, have accumulated so much more debt, leaving them even more beholden to low policy rates – a factor that’s not lost on central banks themselves. Nonetheless, even for governments, the cost of central banks not hiking enough is likely to be far higher than if the central banks err to the hawkish side.

While this is our view, we do feel that the Fed will continue to err to the dovish side too much, even if it is undoubtedly trying to correct towards a tougher policy footing via a likely increase in the pace of tapering at next week’s FOMC meeting. While a faster taper is discounted and may even produce a ‘buy the rumour, sell the fact’ slide in yields initially, we remain of the view that the directional skew for yields is to the higher side and we still think that 10-year treasury yields will be over 2% in the next year, or so. While inflation is clearly not a problem restricted to the US, we tend to view it as a more difficult problem for the Fed to tackle for two main reasons. One is that it has geared its policy to an environment where inflation is too low, not too high, as we mentioned earlier. Secondly, the Fed has a particular problem that its policy actions reverberate around the world and hence decisions to tighten without significant warning are almost outlawed – and that is a dangerous place to be when inflation is roaring ahead.