The rise of the yield curve

One of our key themes in the Capital Markets Strategy Team’s 2021 outlook is an above-consensus increase in 10-year U.S. Treasury yields and the subsequent steepening of the yield curve. Over the last week, we’ve seen the 10-year yield shift higher by 15 bps to today’s post-recession high of 1.08%. We would attach the results of the Georgia election and the certification of the electoral college as not necessarily the reason for higher yields but perhaps as the catalyst to push yields above the resistance level of 100 bps and the 10-2 spread to its widest since 2017.

We believe this is the continuation of a push higher for yields on the back of higher and sustained inflation through 2021. Our inflation model continues to suggest a jump higher on base effects from the recession in 2020 with a settling in near 2.5% through the back half of 2021. The consensus view is for inflation to be transitory due to the base effects, yet we’d argue otherwise. Using conservative forecast inputs in our model gives us a period of sustained higher inflation above 2.5%. Our 2021 theme of a rapid reopen of the US economy (and other locked-down economies) presents upside risk in 2021 towards employment, wages, and consumption-led inflation, while the continued quantitative easing program may contribute to inflation through further USD weakness. Nonetheless, we believe inflation risk will contribute to interest rate risk and continue to push the 10-Year Treasury yield higher.

Here’s a chart that shows a strong correlation between the year-over-year Consumer Price Index and the Capital Markets Strategy team’s inflation model. The chart covers data from 1998 to 2020 (and includes a forecast for 2021).
This chart shows the U.S. Treasury yield 10-2 spread from January 2016 to January 2021.There was an overall steady decline from January 2017 to September 2019, but since then, there’s been an overall steady increase.

The December 2020 ISM purchasing manager’s index (PMI) came in at a very strong level of 60.7. Historically, the change in the PMI has correlated with the year-over-year change in the 10-Year treasury yield.  The 10-year has been lagging until this week.  We believe we are in a period of catch-up.

Our work on growth/inflation environments would suggest that if 2021 is as we suspect and experiences an accelerating growth and accelerating inflationary environment, then we could see the U.S. 10-Year Treasury yield at 1.5% within the next six to 12 months. The kicker is that we believe the risk is to the upside. A yield of 2.0% is entirely possible on stronger than expected growth and a willingness by the U.S. Federal Reserve to embrace higher yields (which we believe is already in place given the lack of communication on any yield curve suppression).

Accelerating Growth/Accelerating Inflation

 

Average Change

Stdv

Prob of Increase in Yield

Prob of Increase > 50 bps

 

US 10-Year Yield

US 10-Year Yield

US 10-Year Yield

US 10-Year Yield

US GDP

0.65

0.99

79.7%

57.6%

OECD

0.48

0.79

71.7%

49.1%

CB LEI

0.61

0.83

84.2%

57.9%

ISM

0.45

0.91

69.2%

55.8%

CFNAI

0.33

1.01

64.1%

48.7%

Average

0.50

0.91

73.8%

53.8%

Source: Manulife Investment Management, Bloomberg, as of December 2020
Here’s a chart that shows a strong correlation between the ISM purchasing manager’s index and the U.S. Treasury 10-year yield, from1992 to 2020.

Over the near-term, with the 10-year yield having broken through 1.00%, we’ll be watching the next resistance level of 1.10% (minor resistance) for a break higher to 1.29% (major resistance). So far, 2021 is proving to be a challenging environment for long-duration sovereign bonds. In this regard, we continue to favour investment-grade and high-yield corporate bonds, shorter-duration assets, and emerging market debt for fixed-income investors.

Philip Petursson, CIM
Chief Investment Strategist and Head of Capital Markets Research

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

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Kevin Headland

Kevin Headland, 

Senior Investment Strategist

Manulife Investment Management

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Macan Nia

Macan Nia, 

Senior Investment Strategist

Manulife Investment Management

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Philip Petursson

Philip Petursson, 

Chief Investment Strategist and Head of Capital Markets Research

Manulife Investment Management

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