- There is a growing risk that U.S. yields spike in response to the surge in risk assets and inflation expectations as we saw back in the 2013 taper tantrum.
- Our measure of fair value for U.S. yields suggests the 10-year should be trading around 1.2%, implying negative total returns over the next 12 months.
- We could see investors drive up the long-end of the curve to test the Fed’s commitment to maintaining ultra-loose policy in the face of rising inflation pressures.
There is a growing risk that the U.S. bond market balks at the surge in risk assets and inflation expectations, causing a sudden spike higher in yields as we saw during the 2013 taper tantrum. The explosion higher in Chinese stocks over the past week indicates that the bullish speculative sentiment in the U.S. is extending to overseas markets. Meanwhile, the dollar is threatening to break lower as the pullback extends into a bearish trend.
Our measure of fair value for U.S. yields suggests the 10-year should be trading around 1.2%, implying negative total returns over the next 12 months. While we continue to see deeply negative real yields, there is significant room for nominal yields to rise, given the recovery in inflation expectations. A rise in the 10-year yield back to 1.2% would imply 6% downside for the iShares 7-10 Year Treasury Bond ETF (NASDAQ:IEF), and we see the risk of an even greater selloff as the fundamental backdrop deteriorates.
Ultra-Loose Policy Getting Looser
Based on the spread between bond yields and breakeven inflation expectations, U.S. monetary policy is now as loose as it has ever been with the exception of the late-2012, early-2013 period directly preceding the sharp rise in yields in mid-2013 commonly known as taper tantrum. Yields have remained pinned near their March crash lows, despite surging bond issuance, thanks to record debt monetization which has helped drive the recovery in risk assets and inflation expectations.
Real 10-Year Yields Testing 2013 Lows
The past week’s double-digit jump in Chinese stocks is a clear indication that the speculative sentiment which has driven U.S. tech stocks higher has begun to spread to overseas markets. The Shanghai Composite has extended last week’s gains and looks to be dragging up other Asian and Emerging Markets.
Shanghai Composite Index Breaking Higher
The U.S. dollar is also coming under pressure from the ongoing decline in real yields, with the dollar index threatening to break lower out of a bearish flag formation. Meanwhile, the yuan has joined in the Emerging Market FX rally and looks set for a break back below the 7.0 level.
U.S. Dollar Index Threatening To Break Lower
We are also seeing a strong recovery in the commodity complex and in particular industrial metals prices. The copper-gold ratio, for instance, has bounced 15% from its April lows, decoupling from their long-held correlation with 10-year yields.
Copper-Gold Ratio Decoupling From U.S. Yields
Fair Value 10-Year Yield Around 1.2%
Our fair value measure for 10-year yields, which takes into account the yield curve, industrial metals prices relative to gold, inflation expectations, foreign yields, and credit spreads, currently sits at 1.2%. The current deviation from fair value is almost as large as in 2013 prior to the taper tantrum.
Source: Bloomberg, Author’s calculations
As the chart below shows, previous yield deviations below fair value have been strongly correlated with subsequent total return declines in the IEF. Crucially, these declines have come in spite of the fact that fair value yields themselves have fallen so much. We should, therefore, expect to see roughly 2-3% annual declines in total return terms over the next two years based on historical correlations even if the long-term bull market remains intact. However, there is a growing risk that declines will be greater than this as fair value itself heads higher amid the ongoing asset reflation.
Source: Bloomberg, Author’s calculations
Policy To Remain Loose, But Fed Will Be Tested
We continue to expect real yields to remain negative as monetary policy remains extremely loose. However, there is significant room for yields to rise while remaining in negative territory in real terms. As much as U.S. policymakers are happy with deeply negative real interest rates, a weaker dollar, and rising stocks, they are unlikely to want to risk a surge in inflation and a disorderly decline in the dollar. Further cutting short-term rates into negative territory, as markets are currently expecting, at a time of deeply negative real yields and rising inflation expectations, poses the risk of undermining confidence in the dollar, and we could see investors drive up long-end of the curve to test policymaker’s resolve.