THE next leg higher in long-term Treasury yields may come from what's known as real rates, one of the bond market's purest reads on the growth outlook. A burst of strong economic readings - a mammoth job creation figure on Friday and now a report from the Institute for Supply Management showing record growth in service industries - is fuelling bets that expectations for growth, not inflation, will dominate the narrative in Treasuries.
That's an important distinction because while higher real rates, which strip out inflation, suggest investors see the economic rebound from the pandemic gaining steam, a persistent rise may hurt other assets, including stocks. Relatively risky assets could start to suffer with the market signalling that it sees growth getting so strong that it expects the Federal Reserve to start discussing a tapering of its asset purchases as a step towards tightening policy.
Ten-year US real yields - as measured by the rate on inflation-linked Treasuries - are about minus 0.65 per cent, near the highest since mid-2020 and up from a record low of negative 1.12 per cent in September. The last time Fed tapering was in the offing, the real yield flipped from decidedly negative to firmly positive over the year through December 2013 - when the Fed said it would begin cutting its asset purchases.
"We note the strong March payrolls and ISM readings as early signs of a surge in strong economic data, which when combined with the prospect of further fiscal expenditures, should be sufficient to push yields higher still," Praveen Korapaty, chief rates strategist at Goldman Sachs Group Inc, wrote in an April 2 note. "However, a smaller inflation pick-up may tilt the composition of any yield increases more heavily towards real yields."
Ten-year nominal yields are about 1.7 per cent, holding below the 1.77 per cent level reached on March 30, the highest since January 2020. Mr Korapaty forecasts the 10-year yield will end 2021 at 1.9 per cent and move to 2.1 per cent a year later. Christian Mueller-Glissmann, a portfolio strategist at the bank, told Bloomberg Television on Tuesday it could overshoot to as much as 2.3 per cent in the second quarter.
Most Wall Street strategists say that before lifting rates, the central bank will begin to ponder trimming its bond purchases, a move that's been a catalyst for higher real rates in the past. Pacific Investment Management Co said the Fed may begin discussions in June to wind down its asset purchases, while Morgan Stanley predicts it will announce the start of a tapering programme in January.
The 10-year real yield moved from about minus 0.6 per cent in January 2013 to positive 0.76 per cent by December 2013. A surge in inflation expectations has played a big part in driving yields higher in recent months. A bond-market proxy for the pace of US consumer prices over the next decade is at 2.35 per cent, close to a multi-year high.
But the bond market is well aware that while inflation is on course to rise, in the months ahead any notable pickups will be due to base effects, or a comparison to the abnormally low numbers seen last year when the pandemic crushed expectations for growth and price pressures.
The March jobs report is likely to herald the start of even more positive signs on growth, according to Jefferies economists Thomas Simons and Aneta Markowska. While it's early for the Fed to declare victory on its goals, the strong data should spark the central bank to open the door to tapering discussions, likely at their June meeting - with an announcement in the final quarter of the year, they say. BLOOMBERG