Will the Real Yield Please Stand Up?!

rising-yield

Macro

  • Our real gross domestic product (GDP) forecast for 2026 is 2.5% (based on our Global Investment Management Survey) versus the Federal Reserve’s (Fed's) forecast of 2.2% and the Wall Street consensus of around 2%. Last week the final revision for the second quarter came in at a 2.2% annualized growth rate, vs. expectations of a 1.5% annualized growth rate. The economy remains resilient. I’m not a big fan of the Atlanta Fed GDPNow (“nowcasting” model), but note its forecast for the third quarter is 3.73% (as of October 1). The only thing that could throw us a curveball would be a significant policy shift by the Fed; meaning, it signals the beginning of a prolonged rate-hike cycle. It’s hard to “signal” when forward guidance is not a thing anymore. More on what rate hikes mean for equities and fixed income below.
  • On the inflation front, the core Personal Consumption Expenditures (PCE) price index year-over-year (Y/Y) was 3.0% for August, vs. expectations of 3.3%. July’s number was also revised lower, from 3.3% to 3.0%. Looking at the monthly core PCE price index, August was 0.2% vs. 0.3% expected and, again, the prior data was revised down, from 0.2% to 0.1%. Changes in the calculation seem to be the driver of weaker numbers vs. expectations.
  • The Institute for Supply Management (ISM) September manufacturing number was 54.5, vs. expectations of 54.7. A reading over 50 indicates economic expansion. The ISM Prices Paid Index (representing input costs across major commodities) was 77.9, vs. expectations of 73, and the ISM New Orders Index number was 55.3, vs. expectations of 54.
  • The 2-year note yield is currently 4.88%, roughly 88 basis points (bps) over the fed funds rate. Remember, the bond market leads the Fed, not the other way around (as we just saw). Two-year yields continue to call for additional rate hikes. We expect one additional rate hike this year. The US 10-year bond yield is currently 5.30%, and the 2-10s curve has bear steepened significantly to 41 bps, as of this writing, up from 21 bps on September 23.
  • Breakeven rates have moved higher, especially the one- and two-year measures. One-year breakeven rates are 2.70%, 2-year breakeven rates are 2.50% and 5-year breakeven rates are 2.37%. These numbers represent the bond markets’ pricing of annualized inflation out one, two, and five years. Breakeven rates and the 2-year note are now giving the same message: Something needs to be done to address inflation. The bond market is telling the Fed to raise rates again.
  • Real yields have moved higher, a reflection of a strong economy. Real yields are calculated by subtracting the breakeven rate from the nominal rate. For example, US 10-year yields are 5.30% and the 10-year breakeven rate is 2.37% (5.30% - 2.37% = 2.93%). This is the highest level for real yields since 2008. Real yields are driving 10-year nominal yields higher, not so much inflation. I would argue that’s a good thing.
  • Meanwhile, the fed funds futures market is indicating a 37% chance of a 25-bps hike at the October Fed meeting (basically cut in half from last week’s odds) and an 81% chance of a hike in December. The futures market has the 2026 terminal fed funds rate at 4.23%—it believes another hike is coming. We agree and it looks like December.
  • On the currency front, we are expecting the US dollar to be essentially flat for the year despite the recent volatility. The US Dollar Index (DXY) is trading at 101, still firmly range-bound as it has been for the past 17 months, but is testing the upper end of that range now. I would note that the DXY has been a consensus short for the last few years.

See more: Stock Market’s Wall of Worry Gets Taller