What’s triggering higher yields?
In what seems to typify modern markets, price and yield moves that used to take several months, now happen in a matter of weeks or merely days. The start of 2018 has been characterized by volatility and another leg higher in yields. The market has quickly grasped ahold of the themes mentioned in our most recent Fixed Income Commentary, namely that higher inflation, growth, and budget deficits will lead to increased market yields in the year ahead.
Inflation seems poised to move upwards, at least modestly, with wage growth and prices for goods and commodities trending higher. Growth, as measured by real GDP, has been above 3% in two out of the last three quarters and may potentially receive a boost as a result of the recently enacted Tax Cuts and Jobs Act. A side effect of this legislation is an estimated $1.5 trillion reduction in government revenues over the next decade, which will lead to an increase in government borrowing. To this point, the U.S. Treasury Department recently announced it will be increasing the size of upcoming bond and note auctions by $42 billion in this quarter alone. For the first quarter of 2018, Treasury officials announced that they will need to borrow $441 billion, the largest amount since 2010.
Source: Government Accountability Office (GAO) Citizens’s Guide 2016
More Treasury supply, coupled with stable demand, has predictably led to an increase in yields. With the 10-year Treasury having already increased to 2.8%, it is approaching our year-end forecast of 3%. Many fixed income strategists have moved their forecasts higher, but we are maintaining our target.
10-year Treasury Yield
With the Personal Consumption Expenditure (PCE) price index at 1.5% year-over-year and wage growth sitting at 2.5% year-over-year, inflation is mostly in the form of expectations at this point. A substantial increase in rates will require inflation to materialize rather than fading as it has in previous years. Ultimately a balanced, well-structured portfolio of individual bonds is still well-positioned to provide portfolio stability and a known income stream in both calm and volatile markets.
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