US yields race ahead

The reflation trade has taken hold of markets and pushed US Treasury yields consistently higher at the long end of the curve. Current yields on 10yr USTs of almost 1.4% are well above our conservative estimates for yields to hit 1.10% at the end of 2021 and we are marking our expectations to market accordingly.

US bond yields have surged higher in line with rising inflation expectations on the back of signs that the US economy is recovering faster than expected from the Covid-19 pandemic as well as the anticipation of USD 1.9trn of fiscal spending, including considerable cash handouts to households. We had expected the Biden administration would attempt to make a bipartisan deal and thus spending levels would be lower than initially proposed but by making use of the budget reconciliation process, the administration can bypass requiring any Republican support in the Senate.

UST 10yr yields chase inflation breakevens higher

Source: Bloomberg, Emirates NBD Research

We still remain cautious on how meaningfully elements of the USD 1.9trn relief bill will contribute to pushing inflation higher this year (see Inflation and the Fed, published Jan 28 2021). Among the inflationary elements are additional cash handouts of USD 1,400/adult and a higher federal minimum wage. But spending on vaccination programmes, relief for state and local governments, rental assistance, a halt on evictions or additional food stamp benefits don’t address the considerable slack that still exists in the US economy.

Upside inflation risks likely to be short-term

The upside risk for inflation is whether the additional cash handouts—which may be spent or saved—and higher minimum wages will compound the apparent underlying strength in the US economy. PMI data for the start of the year has held up very well in both manufacturing and services, hitting 58.5 and 58.9 respectively while retail sales surged over 5% m/m in January. We had expected that yields would track improvements in the US economy this year but the pace of recovery has been sharper than anticipated. The upward push in inflation-adjusted yields—adding almost 30bps since mid-February to hit -0.79% on 10yr currently—could add further legs to the upward push in nominal yields.

Federal Reserve leadership continues to indicate that any boost to prices this year will be transient and won’t address the persistent disinflationary trends impacting the US economy. Markets will be closely tracking Fed chair Jerome Powell’s statement to Congress this week for any effort to talk down the surge in yields.

We believe there is scope to yields to come off from their current one-year highs and are targeting a pull back to 1.2% on the 10yr for the end of Q1 (compared with 0.85% previously) and we expect to see a steady push higher over the rest of 2021 with yields coming back to 1.4% by the end of the year, provided there is no sustained downswing in the economy or resurgence of Covid-19 cases. Importantly, almost all the action in the UST market is happening on the longer end of the curve. Fed statements have given no indication that policy rates are moving higher this year or next and a pending unwind of the US Treasury department’s cash account will keep downward pressure on short-term rates acute. We expect UST 2yr yields to remain low, rising to just 0.15% by Q4 and contributing to a steadily steepening 2s10s curve over the course of the year.

Source: Bloomberg, Emirates NBD Research.