The US government bond market is signalling that the Federal Reserve will be able to boost interest rates to tame inflation without snuffing out growth in the world’s biggest economy.
Real yields, the returns investors can expect to earn after inflation is taken into account, have jumped sharply in a sign that traders are expecting the US economy to continue expanding in the years to come even as policymakers withdraw stimulus measures to slow intense price growth.
The yield on 30-year Treasury Inflation-Protected Securities (Tips) — a proxy for the real yield on the 30-year Treasury bond — broke above zero on Friday for the first time since June 2021. It closed last year at minus 0.47 per cent, according to Bloomberg data.
Investors said the rise in real yields and relatively anchored inflation expectations indicated that the Fed was well-placed to tighten monetary policy without stalling the recovery from the pandemic.
“The Fed’s control over the economy has just increased,” said Robert Tipp, head of global bonds at PGIM Fixed Income.
The market moves were an acknowledgment of the US economy’s strength and the robust outlook, according to investors.
In 2021, the US economy rebounded from the historic pandemic-induced recession by growing at the fastest annual pace since 1984. Vaccines, a return to work and robust federal stimulus have all bolstered the rebound. But until recently, that had not been reflected in the Treasury market.
“Real rates were just absurdly low compared to economic fundamentals. So it only makes sense that they should be rising,” said Gregory Whiteley, portfolio manager at DoubleLine Capital.
Friday’s much stronger than expected jobs data was just the latest in a series of indicators to illustrate this recovery.
The closely watched US payrolls report showed the economy added 467,000 jobs last month despite the recent rise in Covid-19 cases. It also included a substantial surprise upwards revision in jobs figures for November and December, and showed that wages had grown by more than expected.
The market responded by sending yields on US Treasuries jumping, with the 10-year yield hitting its highest level since January 2020.
The strong jobs report could have driven inflation forecasts higher: more jobs and higher wages give workers more money to spend, driving up demand for goods that are scarce because of problems in the supply chain.
Instead, traders have coalesced around the view that the Fed has more room to lift interest rates and cool the economy. Market measures of inflation expectations for five, 10 and 30 years in the future, known as break-even rates, largely held steady.
As a result they ended the week by upping their estimates of how many times the Fed would tighten policy this year to five quarter-point rate rises, from between four and five a day before.
“Either the entire inflation market hasn’t gotten the memo or they have got the memo and the memo says inflation is going to come back to normal by the end of the year,” Chris McReynolds, head of US inflation trading at Barclays, said on Thursday.
Yields on longer dated break-evens are “very well contained. There’s no thought of sustained levels of inflation”, he added.
Real rates are still depressed by historical standards: the yields on five- and 10-year Tips notes remain below zero. Without further movement in real rates — or without a shift in inflation expectations — the yields on traditional Treasury bonds could stay low even as the Fed lifts interest rates.
Though the pace at which consumer prices are rising is expected to have hit a fresh 40-year high in January, there is some evidence that momentum may finally be starting to flag.
Economists polled by Bloomberg have forecast that core consumer inflation, which removes the effects of the volatile energy and food sectors, will rise in January at a slower pace than in December. Barclays economists cited moderation in the price pressures on clothing and on used cars for the expected shift.
“I’m a believer that the Fed missed the whole inflation thing, that they spent too long insisting it was transitory. But that was the 2021 scenario,” said Andy Brenner, head of international fixed income at NatAlliance Securities. “I do believe that inflation is going to subside.”