Equities are outperforming bonds, yields are rising, and the US curve is super-steepening. The Fed is doing a reasonable job of anchoring short-term interest rate expectations, but the longer end of the curve reflects the reflationary boom. It is making US fixed income attractive again. Yet the move up in yields is probably not over and few will be surprised now if and when the market crosses the 2% yield level. That is no disaster. The US economy is in fully party mode.
It is worth thinking of how high yields could go. One metric would be to think about where long-term inflation expectations will settle and where real yields will settle. Our view is that inflation break-evens at around 2.4% are consistent with the Fed’s average inflation target. Real yields have averaged 0% since the global financial crisis. Putting the two together would target 2.4% 10-year Treasury yields.
A second approach would be to look at the cyclical position… by looking at current yields relative to their 3-year average and plotted that against the ISM index of manufacturing activity. There is a good fit in terms of how they behave through the cycle and it suggests that the level of yields is still too low relative to where the economy is. This is not an econometric model, but it could be used as an argument to point to yields being closer to 3%. At any rate, it should not be surprising if yields move higher still – after all that is what forward markets are pricing.