Schroders: What is Driving US Treasury Yields Higher?

“…our program for reducing our [Fed’s] balance sheet, which began in October, is proceeding smoothly. Barring a very significant and unexpected weakening in the outlook, we do not intend to alter this program.” – Jerome Powell, Chairman of the Federal Reserve, 21 March 2018

  • Global economy is decisively moving from the recovery phase of the economic cycle to the expansion phase; the transition occurs as most countries start to experience shortages in spare capacity, causing firms to bid-up input prices including wages, which in turn drive demand higher; as a result, inflation is typically higher, prompting central banks to tighten monetary policy
  • Bond yields tend to rise during this phase of the cycle as investors demand additional compensation not only for rising inflation, but also the higher potential returns on equities, driven by stronger economic growth
  • As yield rises, so does the discount rate applied to forecasts of future income growth for equities, therefore reducing the present value and making equity valuations less attractive
  • Higher bond yields also increase the opportunity cost of owning risk-assets compared to holding a “risk-free” government bond
  • A nominal yield below 3% is still very low compared to past cycles; however, the current economic cycle is arguably like no other seen before
  • How far should yields rise going forward? What are the key drivers?

Structural versus cyclical factors

  • Over the past year, the Schroders’ model’s fair value estimate has risen by 91 bps; 56 bps of which was caused by the rise in the manufacturing ISM survey; this was the most important factor, followed by the rise in the real Fed fund rates (+27bps) and the reduction in QE as a share of GDP (+9bps)
  • VIX volatility index remained subdued and therefore had no impact; however, the overseas official holdings of Treasuries as reserves made a small negative contribution
  • Given that growth and the Fed funds rate are estimated to have had the largest impact, we conclude that cyclical factors have so far been the key drivers of the rise in yields
  • Looking ahead, our forecast assumes that growth will peak in 2018 and begin to moderate over most of 2019
  • While nominal interest rates are forecast to rise further, the real rate is only forecast to rise a little further in 2019 given our forecast of rising inflation
  • The main driver of higher yields over 2018 and 2019 is forecast to be the reduction of the Fed’s balance sheet, which is set to accelerate over 2019
  • Fed’s policy of unwinding QE is likely to be more of a structural headwind for the bond market in the coming years, rather than policy driven by cyclical factors
  • Balance sheet reduction is set to accelerate from $20bn per month to $50bn per month by the end of the year
  • Unless there is a significant downturn in the economy, the Fed is unlikely to waver from its path of allowing its balance sheet to shrink

What about inflation?

  • When you add historic core inflation and our baseline forecast for core inflation, estimated fair value of the 10-year nominal yield is forecast to rise by 166bps to 4.29%
    • This is made up of the 51bps increase in the real yield and 115bps rise in core CPI inflation
  • A forecast of 4.29% for the nominal 10-year Treasury yield would be considered as aggressive today, despite historic yields being much higher in the past
  • Not only is there considerable upside risk to Treasury yields over the forecast horizon, but also to market pricing of the future path of yields

Schroders US Real Yield Model Conclusions

  • Combining the model with our baseline forecast to look ahead, we conclude that these cyclical factors are likely to moderate, though structural factors in the form of the unwind of QE will drive real yields higher
  • Once higher inflation is also factored in, the model’s 95% confidence interval suggests that the nominal 10-year Treasury yield could rise to between 3.78% and 4.8% by the end of 2019
  • If yields do rise in line with the Real Yield Model’s forecast, or even by more, then equities could struggle to make gains, especially where earnings growth is weak or hard to identify

Schroders Economic and Asset Allocation Views Q2 2018

Image Source: Schroders Economics Group