Views on Interest Rates and the Move in Treasury Yields

Jacob Hess

March 21, 2021

• Interest Rates
• Inflation

Treasury yields are front in center in March 2021 and look to continue to be in the spotlight through the end of the year. The steep rise comes at a point while interest rates are at the lowest they have ever been, so the description of these rates as "high" is relative to the near-term environment that they exist in. The most recent 5-year Treasury yield was 0.82% which is 45 bps higher than the beginning of the year (an increase of over 120%). However, that yield is well below the average yield from 1962 to now of 5.68% and below the average of 1.51% since 2010. There's been a lot of discussion about how yields will affect markets. Here are a few views from bank commentary from the last week.

A recent Morgan Stanley report compares the current situation to the "taper tantrum" in 2013 when markets reacted fearfully to the Federal Reserve's suggestion that quantitative easing might end sooner than expected. The Fed ultimately calmed the market's fears and sentiment improved. Morgan Stanley does not see that playing out here. Instead, they see rising Treasury yields in 2021 as "explained by a pricing-to-market phenomenon" and not as "impactful" on credit conditions or equities. Overall, they view the move as rooted in optimism and unlikely to "derail" the economy. On the other hand, risky assets might see some volatility.

That view was supported by FOMC members' projections for 2021 that were revealed after their March meeting. Their median inflation forecast increased from 1.8% to 2.4% suggesting that members may have underestimated overheating in prices and may have to consider controlling them in the near future. Despite the bond market believing in this possibility, Wells Fargo most recent weekly report does not align with that thinking as they see a Fed that is "in no rush to tighten" despite the increase in inflation forecasts and the improvement of GDP and unemployment forecasts. As a result, Wells Fargo sees near-term Treasury yields "at essentially 0%" while long-term yields respond to optimism and higher future growth by rising.

JPMorgan mirrors the belief that central banks will not tighten any time soon and thinks that policy rates won't be raised until "around the end of 2023." That's not for a lack of optimism. JPMorgan also thinks that there is a 90% chance of above-trend GDP growth in the US with a forecast of over 7% for 2021. They see that expected growth as pushing long-term yields higher while "the Fed controls the normalization of 10-year US Treasury yields toward a 0% real yield." This rise shouldn't cause volatility in financial conditions if it occurs "over the next few quarters."

Merrill Lynch's recent Capital Market Outlook continues to stress its view that the Federal Reserve is underestimating inflationary pressures and sees inflation above 2% happening sooner rather than later especially with huge government spending on deck via the stimulus bill. Similar to its peers, Merrill Lynch does not see the Fed moving against inflation anytime soon. Instead, they believe that the monetary policy will remain accommodative as long as the labor market has not acheived "full and inclusive employment." These factors will combine to result in a steepening of the yield curve.

Merrill goes a step further and says that the positive correlation between bonds and stocks seen so far this month is "unlikely to remain on a long-term basis." The flip from negative to positive correlation while Treasuries correct has happened twice before this decade, in 2013 and 2016-2018. In both instances, the positive correlation did not last long, and Merrill sees this as an indicator that volatility in markets will be short-lived. Summed up in a line, "We do not expect the recent move to be a regime change, but rather a likely and expected consequence of a small rate shock."

Commentary has been heavily focused on interest rates because of the large move. The consensus seems to be that, despite market yields increasing, the Fed is not interested in reacting to higher inflation prospects. Furthermore, the reports also insist that the move in yields is a healthy reaction to optimism and shouldn't worsen financial conditions if the rise is a gradual and not a shock.