US 10-year yields rose above 2.0 percent last week. The last time 10-year yields were above 2.0 percent was in July 2019. With skyrocketing inflation and the Fed’s upcoming rate hikes in mind, that probably does not sound so crazy. Yet our model estimate for US 10-year yields points in the opposite direction.
We estimate US 10-year yields using the following factors:
- US unemployment rate
- US short-term interest rate
- The Fed balance sheet as a percentage of GDP
- US core inflation rate
- The US term premium
Inflation drives interest rates down
Based on these factors, each of which explains a significant part of interest rate movements, the US 10-year rate should stand at 0.98 percent. That’s almost a full percent lower than the current market rate. It is mainly core inflation of 5.5 percent and the negative Term Premium that pull down the model estimate. The relationship between long-term interest rates and core inflation is negative. If inflation really gets out of hand, the Fed will have to intervene to bring it back under control.
The Term Premium
A common definition of the term premium is “the compensation investors demand for the risk that interest rates may change over the life of a bond”. That risk is normally greater in longer-term bonds, which is why the Term Premium often is - or has been - positive. One reason for a very low Term Premium can be decreasing volatility in inflation and growth rates. But what also plays a role is the Fed’s extraordinary monetary policy that partly distorts the Term Premium.
Peak tightening anxiety
The large difference between actual and estimated 10-year yields has made US government bonds more attractive. And with markets pricing in more than five Fed rate hikes this year, we are also getting close to the peak of tightening anxiety. A number of factors, including lower inflation, declining GDP growth momentum, and the likelihood of a larger stock market correction than we have just seen, limit the Fed’s scope for enacting all those rate hikes this year.
Positioning
Historically, many multi-asset investors are still underweight government bonds. When momentum weakens and investors reverse those positions, this can lead to substantial interest rate declines. While many investors are still digesting the hawkish messages from central bankers, the outlook for US government bonds has become much more positive.