The recent jump in U.S. Treasury yields has spooked investors. Not all yield rises are the same. Yields driven up by rising policy rate expectations may harm equity valuations. We see the recent yield spike as partially correcting the disconnect between the powerful restart and falling yields that had led to an overly compressed term premium. We see this as a more benign adjustment, and view ongoing negative real yields and the broadening restart supporting risk assets.
What’s driving the yield spike?
U.S. 10-year Treasury yield breakdown, 2012-2021
Past performance is no guarantee of future results. Sources: BlackRock Investment Institute, with data from Haver Analytics, September 2021. Notes: The chart shows breakdowns on the drivers of U.S. 10-year Treasury yields based on historical market pricing of expected real rates, expected inflation and the term premium. The term premium – or the amount investors expect to be compensated for lending over long periods – is based on a model similar to Andreasen et. al. https://www.frbsf.org/economic-research/files/wp2017-11.pdf (2017).
The market narrative that the spike in yields is driven by concerns about higher U.S. policy rates misses the point, in our view. We see a more compelling driver: an overdue correction of the disconnect between low yield levels and the economic restart. We had argued since the spring that yields were too low given the broadening restart and this would ultimately be corrected. Back then it took weeks for yields to rise about 20 basis points to 1.50% level, and this time it only took a week – underscoring our view that markets may be catching up to the reality of the restart. We see more drastic yield increases as unwarranted. Our analysis also shows the latest yield spike was driven by an increase in the term premium – or the compensation demanded by investors for the risk of holding longer-term government bonds. See the chart above. We believe higher term premia in this environment need not be bad news for equities, and still very negative real yields remain supportive of the asset class. Over the next six to 12 months we stay overall pro-risk even as we believe the path for further gains in risk assets has narrowed after an extended run higher and there could be bouts of volatility, including in the bond market.
Markets have been jittery after an extended run higher in risk assets. We see it particularly important to have an anchor in such a noisy market environment, such as our view that we are going through an economic restart rather than a typical business cycle recovery. U.S. growth momentum has already peaked, and this is not surprising to us given the nature of the restart. You can only turn the lights back on once, so to speak. We have also long warned against extrapolating too much from volatile near-term activity data amid unusual restart dynamics. We also firmly believe in our new nominal theme – Short-term yields will likely stay lower than they would have in similar past periods as central banks keep policy accommodative, and longer-term yields will gradually rise on the back of a revival of term premia and higher medium-term inflation. This is why we don’t find the recent Treasury yield spike alarming; and why we uphold our pro-risk stance and stay broadly underweight government bonds, particularly for longer maturities.
Against this backdrop we expect real interest rates to stay firmly in negative territory, supporting risk assets. We are modestly overweight equities on a tactical horizon, with a preference for cyclicality and quality. This is expressed through our regional views. For example, we are overweight European equities as we expect this market to benefit more from the broadening global restart. In fixed income, we have recently shifted our tactical stance on emerging market (EM) local-currency debt to a modest overweight. We do not see the recent yield backup – or the Fed’s tapering – leading to an EM tantrum given higher real yields and improved external balances in EM economies.
The bottom line: We view the recent U.S. Treasury yield spike as resolving a disconnect between the restart and low yield levels, and not reflecting a hawkish pivot by central banks. Our new nominal theme has played out this year and remains a key anchor of our views, including our expectation for longer-term yields to gradually push higher while front-end yields stay anchored. We also see the new nominal supporting risk assets, especially given the still robust growth backdrop. Over the next six to 12 months we stay overall pro-risk but see a narrowing path for risk assets to push higher – with the potential for bouts of volatility. We are strongly underweight U.S. Treasuries as we see a gradual rise in nominal yields even with the Fed poised to start tapering by the end of the year. We prefer Treasury Inflation-Protected Securities over nominal bonds for portfolio duration exposure, especially after the recent pullback. We are underweight global investment grade credit as we see little room for further yield compression. Read our detailed views in our Q4 Global outlook update.