USD Rates: Real yields are too low


Real yields not reflecting upcoming Fed normalization.
Eugene Leow14 Sep 2021
    Photo credit: Unsplash Photo


    Implied real yields for US Treasuries have stayed anchored even as the Federal Reserve indicated at June’s FOMC meeting that normalization is upcoming. Most of this can be attributed to compressed term premium and general expectation that the Fed would keep policy settings loose for an extended period. While it has been clearly communicated that the Fed has shifted to an Average Inflation Targeting (AIT) regime, we are not convinced that real rates should be this low.

     

    First, inflation has been more persistent and higher than expected over the past few months. It is unclear if supply side constraints would ease up in the near term. The Fed has generally stuck to its transitory inflation view but we think that risks may be tilted to the upside. In any case, excessively loose monetary policy may not increase output or employment but may worsen price pressures and distort market signals further. Second, we think that growth risks may be overpriced in US Treasuries. To be sure, the Delta variant dented global (and the US) growth in 3Q but we may well have crested this wave, with global COVID-19 cases ticking down. Meanwhile, vaccinations are progressing with more parts of the world ready to open up as herd resilience get within sight.

     

    Taken together, we think that real yields should rise as market participants recognize that we may be past peak Delta fears and a period of recovery could lie ahead. Moreover, we are not convinced that the Fed would want real yields to stay this low when they shift focus towards inflation and normalization. To put things into context, 10Y real yields generally hovered between zero to 1% post taper tantrums in 2013. This rate is close to -1% currently. Assuming long-term US inflation of 2% and neutral real yields of between -0.5 to zero percent, nominal 10Y yields can comfortably hover in the 1.5-2.0% range (similar to levels seen pre-pandemic). 

     

    Eugene Leow

    Senior Rates Strategist - G3 & Asia
    eugeneleow@dbs.com


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