Rising growth and inflation expectations have been driving up U.S. Treasury yields since the election. This week’s chart shows that the reason behind today’s yield jump is quite different from that behind the episode during the bond market selloff of 2013.
The chart illustrates the two factors behind the yield jump during the two periods. One factor is inflation compensation, as reflected in U.S. inflation-linked bonds (TIPS). The other is real rates, or bond yields minus the market pricing of future inflation. The current inflation pricing suggests that investors see the positives of stronger economic growth ahead.
Why this time is different
The jump in yields back in 2013 represented expectations that the Federal Reserve’s (Fed’s) end to bond purchases would not hold down rates further and rate rises were ahead. This was seen suppressing future growth and inflation, given worries about the fragility of the economy. That real rate-driven move sent the U.S. dollar higher, dented equities and sparked a selloff in emerging market (EM) stocks and bonds.
Fast forward to 2016 and the yield spike has been driven as much by the inflation outlook as real rates. Fears of deflation, dominant earlier in the year when oil prices plunged, have faded. Inflation expectations are rising due to pickups in wages and growth, as well as likely fiscal stimulus. Since higher growth and inflation can benefit EM growth without hitting currency values, EM assets and commodities are holding up better.
Investors are not expecting a surge in price pressures. The TIPS market is pricing in average inflation of 2.0% over the next decade, compared with 2.6% before the taper tantrum. We expect that pricing to keep edging up, which is why we favor TIPS. The latest changes to our asset views in our 2017 Global Investment Outlook also reflect broadening global reflation. We now like Japanese equities and have raised our view European stocks to neutral, while we are underweight U.S. Treasuries.
Read more market insights in my Weekly Commentary.