Why Yields Fell, and What Happens Next
In our baseline forecast, the recent decline in U.S. Treasury yields will reverse somewhat, as some of the near-term factors pressuring yields lower ebb. Yet we acknowledge the risks that yields could well fall further. Looking long term, we expect yields in developed countries to remain range-bound at relatively low levels.
In the beginning of August, the 10-year U.S. Treasury yield had dropped to 1.18%, down significantly from a post-pandemic peak of 1.75% in March. We believe the decline is due in part to macro forces, including fresh fears about the pandemic hindering economic recovery. A confluence of technical and fundamental factors contributed to the drop in yields, too. Currency hedging costs fell to a multi-year low, increasing the attractiveness of higher-yielding U.S.-dollar-denominated bonds to foreign investors. U.S. private pension funding levels reached a 13-year high, encouraging pension investments in fixed income securities. A typical summer lull in bond supply also played a part, along with an unwinding of excess bearish sentiment toward Treasuries, particularly among leveraged investors.
Over the coming months, rate volatility could well persist, though in our base case view we expect yields to edge modestly higher back into a range of about 1.5%–2% as some of those factors pressuring yields downward begin to ease. Numerous developments could contribute to rising yields. For one, some of the supply-related factors that have recently boosted inflation could persist for longer if the recovery gathers pace. This includes the U.S. labor market, which could potentially reach levels consistent with full employment sometime next year. This could boost inflation fears in the bond market. Second, an eventual end to Treasury purchases by the Federal Reserve would remove an important buffer against excess Treasury selling that might take place if market participants become less sanguine about the rate climate.
There are risks to our view: Yields could continue dropping. Investors observing the trends toward “peak everything” – peak economic growth, peak stimulus, peak inflation – may decide that yields have also plateaued. In addition, with many financial assets nearing full value, even a smidge of bad news could rattle risk markets and bolster demand for bonds. There is also the risk of further delays in the global recovery owing to the uncertain path of the pandemic. Finally, foreign demand for U.S. bonds may stay strong given the low or negative yields in many other developed markets.
For the moment, market participants appear calm about the long-term outlook for inflation and Treasury yields. The forces that have constrained yields generally lower for years remain intact, such as demographics, the global saving glut, and the tendency toward excessive use of fiscal resources on consumption – as opposed to productivity-boosting investment.
From an investment perspective, we believe it’s important not to focus on specific yield forecasts and the directional strategies they can result in, preferring to keep duration decisions in a portfolio context and focus on other sources of investment return.
For detailed insights into our views across asset classes, read our July 2021 Asset Allocation Outlook, “Mid-Cycle Investing: Time to Get Selective.”
Tony Crescenzi is an executive vice president, market strategist, and generalist portfolio manager in the New York office. He is also a member of the Investment Committee.