By Paul J. Davies
Treasury markets have calmed this week, but yields are signaling that investors still expect the Federal Reserve to be forced to raise rates sooner than it is saying.
The yield on the 10-year note edged down to 1.593% on Thursday, according to Tradeweb. It had closed as high as 1.730% last week, the highest in 14 months. Yields fall when prices rise.
Investors remain skeptical that the Fed won't be forced to raise rates sooner and faster than it has said. The central bank has pledged to keep monetary policy loose until the economy is on a stronger footing. It also plans to let inflation rise above 2% for a period to offset years of weak inflation in the past.
Expectations of sharper rate rises are particularly visible in yields on inflation-protected Treasurys, which are often called real yields. Real yields represent the true income after inflation that investors can get from very low-risk assets relative to the rest of the economy.
The Fed reiterated last week that its rate-setting committee doesn't expect to increase interest rates until after 2023. However, investors predict that it will, according to Sebastien Galy, senior macro strategist at Nordea Asset Management.
"The market believes that inflation above target for a while will force the Fed to tighten early; the Fed disagrees," he said.
Real 10-year yields haven't fallen back as much as normal Treasury yields in recent days. More significantly, the difference between longer-term and shorter-term yields remains far greater in real yields than in nominal yields. This difference over time, known as the yield curve, illustrates how much investors expect interest rates to rise in the future: A steep curve equals more rate rises.
The gap between 10-year real yields and five-year real yields was at 1.137 percentage points on Thursday, which is up from just 0.538 percentage points at the end of 2020. For normal Treasury yields, that five-year to 10-year gap was 0.783 percentage points, up from 0.550 percentage points at the end of 2020.
This move in real yields suggests that allowing inflation to run hot for a spell would mean the Fed has to be much more aggressive in fighting it later with larger interest rate rises, according to John Higgins, chief markets economist at Capital Economics.
Some investors also fear that a sharper rise in interest rates later will be more destabilizing for other assets such as stocks or riskier corporate debt, which have benefited from a low-rate environment.
But the effect on stock markets could hamper the Fed's ability to tackle inflation, according to Diego Parrilla, fund manager at Quadriga Asset Managers in Madrid. His fund focuses on guarding against asset bubbles bursting. He pointed to late 2018, when interest rates only got as high as 2.5% before stock markets tumbled.
"This shows you can't hike rates to fight inflation," Mr. Parrilla said. "What you'll get is inflation and low rates." This means that investors who are selling long-term Treasurys as a hedge against inflation might get caught out, he added.
Mr. Galy of Nordea said that markets should be able to adjust relatively smoothly while inflation expectations remain below about 3%. For now, the Treasury market is signaling inflation expectations averaging about 2.66% over the next five years, and 2.31% in the five years after that.
"Inflation below 3% is likely fine, moving above is likely not at all," he said. "For now, [expectations] are well south of this threshold, but it is the area of instability that is interesting."
Write to Paul J. Davies at paul.davies@wsj.com
(END) Dow Jones Newswires
03-25-21 1025ET
