Long-term Treasury yields are on the move – how high will they go? Yields have been moving higher for mostly the “right” reasons: Investors are optimistic over the prospects for an economic reopening as vaccine distribution accelerates, and they are heartened by expectations that another massive wave of fiscal stimulus will boost growth (along with the deficit). Also underpinning yields is the Fed’s pledge to allow the economy to “run hot” to offset earlier inflation shortfalls and reduce stubborn slack in the jobs market. Surging inflation expectations have been a key driver of the 10-year Treasury yield in particular, a trend that the Fed has helped fuel with its promise to keep policy rates ultra-low until it sees the whites of inflation’s eyes. Ten-year breakeven rates, a proxy for where investors see the annual inflation rate for the next decade, touched 2.26% earlier this month, their highest since 2014.

Our take: The 10-year Treasury yield has finally busted out of its nearly year-long range to levels last seen in the early days of the pandemic. When we see moves like this, we focus on a purer reading of where interest rates are, e.g., “real” yields, which strip out inflation and offer a better reading of the outlook for economic growth.

Real yields on long-term bonds recently rose above zero for the first time since June.  It’s an important milestone, as real yields are often viewed as a gauge of companies’ capital costs. This new world of higher borrowing costs is beginning to loom large over risky assets, like stocks, but doesn’t appear to be alarming the Fed – yet. We doubt it will anytime soon, as expectations of higher Inflation have probably risen too far, too fast. Why? America’s economy is still nearly 10 million jobs shy of where it was pre-COVID, and any fiscal stimulus-driven boost to growth will eventually fade. It’s a recipe for long-term yields to move even higher in the weeks to come.

US economic data show signs of green shoots. Even in advance of another round of fiscal stimulus, the economy appears to have performed strongly in January despite sky-high levels of new coronavirus cases during the month. Retail sales surged 5.3% in January, blowing away expectations, while industrial production rose 0.9%, a level not seen since before the start of the pandemic. Producer prices surged during the month as well, rising 1.3%. Taken together, the data are an encouraging signal that consumers’ aggressive saving patterns from 2020 are starting to ease – a development which, if it continues, could unleash a torrent of pent-up demand in 2021 should infection levels continue to recede and vaccine distribution broadens.

Our take:  This is what happens when one unleashes the power of fiscal stimulus on one hand (retail sales) and the potential build up of actual inflation pressures on the other (producer prices). It’s hard to see either trend ending if Congress passes another huge fiscal stimulus package and the Fed keeps its foot jammed on the gas pedal. Enjoy the ride.