Despite higher inflation expectations, we believe there is limited scope for a dramatic rise in long-term yields.
The runoff senatorial elections in Georgia last week has pushed the 10-year Treasury yield well past 1% as the results gave the Democrats a majority in Senate once the vice president’s casting vote is included. This so-called ‘blue wave’ means we will likely see more US Treasury issuance this year (although short-term T-bill issuance may be negative) and an increase in the US Federal Reserve’s quantitative easing (QE).
With both houses of Congress now controlled by the Democrats, an additional fiscal package worth USD 750-1,000bn is increasingly likely to be passed in the coming weeks. The increase in the 10-year yield has therefore been driven primarily by higher inflation expectations and is consistent with the Fed’s wish to boost inflation towards its 2% target.
Meanwhile, the Fed continues to be in easing mode as it attempts to revive inflation expectations and keep real yields compressed. QE and forward guidance should remain the Fed’s main tools towards this goal, with a potential increase in QE in March and further hints that there will be no rate hikes until 2024 helping to limit the rise in the 10-year yield.
Strong base effects resulting from last year’s price falls could mean we see a jump in year-on-year data for personal consumer expenditure (PCE) and headline inflation in the first half of 2021. This prospect probably helps explain the recent rise in long-term inflation expectations. However, our central scenario is that any jump in inflationary pressures will prove transitory, limiting the upside in inflation expectations.
All things considered, we are revising upwards our mid-year forecast for the 10-year US Treasury yield from 1% to 1.2%. Even though the 10-year yield could continue to spike closer to 1.4%-1.5% in the short term, Fed communication could dampen upward pressure and ensure the yield stays between 0.9-1.2% for most of H1. Our year-end forecast is unchanged at 1.3% and we remain neutral on US Treasuries overall.
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