by Van Luu, Russell Investments
We expect the 10-year U.S. Treasury yield to rise in 2022 and be between 1.5% and 2.0% at the end of the year. During 2022, the yield could overshoot this range. We are bearish on long-term bonds, but not because we believe the U.S. Federal Reserve (Fed) is on the verge of increasing interest rates. On the contrary, we think markets have overpriced interest rate hikes for the next year or so. Upward pressure on long-term interest rates is likely to persist because the supply of Treasury bonds will rise while official sector demand falls. Amid this shift in the demand and supply dynamics, higher 10-year yields are probably needed to bring the Treasury market into balance. However, we do not see the peak Treasury yield for this business cycle significantly exceeding 2.5%.
Treasuries defy rising inflation
As 2021 comes to an end, the financial press has been dominated by reports of surging inflation, supply chain bottlenecks and shortages of a broad range of goods. U.S. consumer price inflation for October came in at 6.2% on a year-over-year basis, and the consumer price index (CPI) excluding food and energy rose by 4.6% over the last 12 months—well over the Fed’s 2% target.1 Inflation rates embedded in 10-year inflation-protected Treasury securities (TIPS) have followed observed price pressures and risen to 2.7%. However, the nominal 10-year yield still only stands at 1.6%, putting the real yield for the next decade at an all-time low of -1.1%.2 In other words, after adjusting for the market-implied inflation rate, bonds are bound to have a negative return when held to maturity. That certainly seems to make them an expensive asset.
Markets see Fed finishing cycle well below our neutral rate
While the U.S. central bank has suggested that it would tolerate a modest overshoot of inflation to make up for low price pressures in the past, it is now getting close to easing off the monetary throttle. As a first step, the Fed recently announced that it will gradually reduce the amount of bonds it buys under the quantitative easing (QE) program, also known as tapering. In terms of the interest rate path, the market seems to have moved to pricing what we could call a policy mistake—a relatively early and rapid series of rate hikes that ends at a Fed funds target rate around 1.50%-1.75%, which would be much lower than previous tightening cycles. Finishing a hiking cycle at such a low nominal interest rate suggests that the economy is too fragile to withstand a more normal policy stance.
It is true that the neutral or equilibrium interest rate (also known as r-star) is likely lower than in previous decades. While equilibrium rates are unobservable and difficult to estimate, our own modelling work triangulating between several theoretical and statistical approaches points to a r-star of around 2.25%. That suggests that the Fed should get to r-star during an interest rate hiking cycle (or slightly exceed it if inflation pressures build up toward the late cycle phase).
Slower but longer hike cycle, higher 10-year yields in the U.S.
In a recent blog post, our chief investment strategist for North America, Paul Eitelman, argues that the risks are skewed to a slower tightening profile than what is currently discounted. We believe that the Fed will start later and initially go more slowly, but ultimately be able to reach a higher terminal rate than what money markets are pricing.
What does this mean for the 10-year Treasury yield? Our valuation approach for Treasury bonds models the fair 10-year yield as a function of the average Fed funds rate over the next decade and an appropriate term premium. Using this approach, we arrive at a fair value 10-year yield of 1.8%, informing the range of 1.5% to 2.0% that we expect to prevail toward the end of 2022. During the course of the next 12 months, we see the risk of the yield breaching the upper bound of that range as the supply-demand picture becomes less favorable. On the supply side, we project that the U.S. Treasury will need to issue more government bonds to finance the current pace of public spending. On the demand side, tapering represents a reduction in the official demand for bonds to the tune of $15 billion per month.
Looking through the business cycle, we often observe that the 10-year Treasury yield peaks around the terminal Fed funds rate, and that it arrives at the peak shortly before the policy rate reaches its highest point. Our estimate of r-star puts the peak Treasury yield for this business cycle around 2.25% to 2.5%, barring the ability for the economy to unexpectedly tolerate much higher policy rates.
The global picture
We hold similar views on the other major markets globally. Using the same valuation approach, eurozone and UK 10-year government bonds look more expensive than U.S. Treasuries. The only government bond market of an advanced economy that currently flags up as more attractive than the U.S. is Australia. After the Reserve Bank of Australia abandoned its yield-curve control program, Australian yields rose sharply across the entire curve, making them the cheapest major bond markets on our valuation model.
The bottom line
We expect U.S. Treasury yields to rise and potentially breach 2.0% in 2022, but not because of a more hawkish Fed or high inflation. On the contrary, we see the Fed being patient and slow with hikes, which will ultimately allow the central bank to go higher on the Fed funds rate later in the cycle. Ultimately, higher long-term interest rates are needed to balance more issuance by the Treasury with less demand from QE purchases.
1 The Fed’s preferred inflation measure, the core deflator for Personal Consumption Expenditures, was lower at 3.6% year-over-year in September 2021, but still well above the target of 2%.
2 As of Nov. 15, 2021.