INSIGHTS

On April 30, 2018

AAM Viewpoints – 10-year U.S. Treasury Yields Are Back to 3%. What a Long, Strange Trip It’s Been

The 10-year U.S. Treasury broke through the 3% level on April 25 leaving analysts pondering the psychological importance of the level and where we go from here. We haven’t seen the 10-year U.S. Treasury yield reach 3% since December 2013 and it took over four years to get back to that level after reaching a historic low of 1.36% in July 2016.

The start of 2018 seems to have caught many investors off guard with a 60 basis points (bps) move higher already this year. To put the magnitude of the move this year into context, the 2.25% Treasury due 11/15/2027 is down 5.15% this year as the price has moved from 98.625 to 93.55. That’s over two years of income lost in 4.5 months and you own a bond that doesn’t mature for another 9.5 years. The good news is it is a safe bond that does have a maturity date so investors know they should receive par on 11/15/2027.

Source: U.S. Department of the Treasury

Meanwhile, the 2-year Treasury yield reached 2.49% (a level not seen in 10 years and up from 55bps in July 2016) as the 1.5% Note due 4/15/2020 has gone from 99.0625 to 98.09375 (-0.99%) and has given up less than one year’s income and will mature in two years at par. Investors only give up 53bps in yield but significantly reduce volatility with the shorter maturity.

 

Source: U.S. Department of the Treasury

The move through 3% is important as chart watchers wonder if a push through the 3.05% intraday high on January 2^nd of 2014 will come next. This represents a turning point in the psyche of investors of both stocks and bonds. The fear is as Treasury yields move higher investors may shift out of equities as the gap between the average dividend yield for the S&P 500 (1.98%) and Treasuries is widening with the 2-year now yielding 2.5%. This adds to the concern that the equity market rally will come to an end. Although a quick move higher in yields from here could rattle stocks, I would suggest this trend higher in yield will not trigger a market reset as Corporate earnings are still very strong (80% of companies reporting so far in Q1 (1^st quarter) have exceeded earnings estimates) and we are likely still in the later innings of the current economic cycle and it’s too early to be calling for a recession.

As you can see below, Treasury yields are pulling up past inflation expectations, and the premium is poised to grow as the outlook for consumer prices picks up. The 10-year breakeven inflation rate, which also sits at levels not seen since 2014, was at 2.17 on April 25 suggesting that investors expect inflation to exceed 2%.

Source: Board of Governors, St. Louis Fed

Through most of 2017 inflation expectations were relatively muted but started to rise at the end of the year. The rebound of the breakeven inflation rate from its December trough reflected predictions that newly enacted tax reforms would spur economic growth and would generate higher inflation. Expectations continued to rise in 2018 in response to positive economic indicators, including solid job creation, rising wages, positive GDP growth and increasing consumer confidence. The March Consumer Price Index (CPI) moved up to 2.4% in March from 2.2% in the prior month. Core inflation, excluding volatile food and energy prices, rose to 2.1% from 1.8%. The two CPI inflation measures are now both above 2% for the first time since February 2017. Economists are also forecasting the core personal consumption expenditures (PCE) price index increasing 2% year-on-year in March after rising 1.6% in February. This suggests to us that the Fed’s preferred core PCE price inflation rate will be running at the 2% target for the first time since 2012.

Source: Board of Governors, St. Louis Fed

The Federal Reserve is keeping a close eye on the rising rate of inflation and it shouldn’t be a surprise to investors that interest rates are moving up. A steadily growing U.S. economy and the lowest jobless rate in 17 years are putting upward pressure on the cost of labor and raw materials. Recent tariffs and higher import prices are also adding to the mix.

Bond investors should be aware that a close above 3% on the 10-year Treasury may lead to an acceleration to higher yields. This is a legitimate concern as we have already moved almost 100bps since September of last year and 166bps since reaching the historic low of 1.36% in July of 2016. A 100bps move is significant when you consider the level of current yields. The sense is that if the 3.05% level is broken easily, rates could move up quickly, and then the 3.20 to 3.25% level that some strategists have set as a year-end target could come into play much sooner. The Fed also meets May 1-2, but at this point is not expected to raise interest rates. Still, it's post-meeting statement could also be something that triggers another move in rates. To prepare for possible moves, up or down in yield, we continue to position our portfolios with shorter duration than their benchmark and the largest coupons we can find. We believe this approach will help us limit portfolio volatility.

CRN: 2018-0402-6530 R