Global Rates Monitor: Turning Neutral On US Bonds

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US 10y yields have been struggling to break out of the 1.60 to 1.70 range since late March. Even last week’s strong ISM and payrolls data failed to spur a move higher. To understand the next likely move in US yields, we can dissect the 63bps rise in US 10y yields over February and March (Chart 1):

We find that at the front-end (2y) – inflation expectations rose (+47bps), while real yields fell (-38bps, Chart 1). Meanwhile, the 2s10s real yield curve steepened sharply (by 82bps), while the 2s10s inflation curve flattened (-28bps). Therefore, the main drivers of higher yields were higher near-term inflation expectations and higher long-term real yields.

The real yield curve steepening was driven by higher growth expectations spurred by US fiscal expansion (Chart 2). With 2021 US GDP forecasts at 5.8% – the highest annual growth since 1984 – upward revisions to growth are now moderating. This suggests less room for the real yield curve to steepen.

The bigger driver, then, would have to be inflation. Near-term breakeven inflation expectations (i.e. 2y inflation swaps) are currently at their highest levels since the global financial crisis. And with oil prices going sideways, there may be less scope for near-term inflation expectations to rise. This leaves longer-term inflation expectations – that is, the inflation curve (2s10s) to have to steepen. At the moment, consensus is expecting inflation to moderate after 2021, which has seen the inflation curve flatten (Chart 3).

Therefore, the swing variable for US yields will be for the inflation curve to steepen. This means the consensus view of a temporary rise in inflation has to be challenged and changed to inflation persistence. Our view is that the combination of the service sector being disrupted and a large output gap should limit inflation persistence. We therefore see less scope for higher US yields in the coming weeks and months and we exit our short UST position.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)