The bond market went into hibernation over the summer, with yields holding steady despite surging inflation, a looming battle over the federal debt ceiling, and the prospect that the Federal Reserve will begin reducing the size of its monthly bond purchases later this year. We see the potential for the market to awaken this fall, with yields moving up.
Currently, 10-year Treasury yields—which move inversely to prices—are sitting below 1.5%. It appears that investors are pricing in a return to lackluster growth and low inflation. We believe the market is too complacent and investors should be prepared for higher yields.
10-year Treasury yields are below 1.5%
Some attribute the persistence of low yields to the Fed’s bond buying program and are anticipating a steep rise in yields as it moves toward tapering its monthly bond purchases. We are also looking for yields to move higher, but in our view, tapering isn’t likely to be the major driver since it’s already a well- known factor for the market.
Tapering: There’s risk in doing too little, too late
Federal Reserve Chair Jerome Powell and other members of the monetary-policy-setting Federal Open Market Committee (FOMC) have clearly indicated over the past few months that they plan to begin reducing the size of the Fed’s bond purchases later this year. The economy has recovered the output lost during the COVID-19 downturn, and inflation is well above the Fed’s 2% target level. Job growth hasn’t fully recovered, but enough steady progress is being made that the Fed is likely to pull back on some of the extraordinary stimulus measures it took in 2020. Consensus expectations are for the Fed to announce a plan to taper at the November meeting and begin the process soon afterward. It will likely take six to 12 months for the Fed to end its bond buying. Tapering shouldn’t surprise the market, so the impact should be limited.
Moreover, there appears to be enough demand among banks, investment and pension funds, and foreign central banks to pick up the slack as the Fed reduces its monthly purchases from $80 billion in Treasuries and $40 billion in mortgage-backed securities. Recent Treasury auctions have been met with strong demand. Although U.S. Treasury yields are low, they are higher than government bond yields in most other major countries, making them attractive to foreign investors.
U.S. yields are above other major developed-country yields
The bigger risk to the market from tapering may be if the Fed takes a very slow approach. Tapering sends a signal that the Fed is pulling back on extra stimulus for the economy. It suggests the economy and inflation will cool off longer-term. If the Fed withdraws the excess stimulus too slowly, it could allow inflation to rise to the point that investors begin to adjust the long-term expectations higher. If the Fed tolerates inflation for too long, it could push yields higher.