Rates on the Rise: How High Will They Go?

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Last Week: Interest rates traded higher as the rally in global equities paused amid growing expectations of at least a temporary burst of inflation in coming months.  All is evolving under an improving growth outlook as vaccine rollouts gather pace and infection levels fall. The yield on the benchmark US 10-year note rose 13 basis points to 1.34%, the highest level in a year. 1-month LIBOR drifted higher throughout the week but remained near record low levels. The price of a barrel of West Texas Intermediate crude oil continued its advance, rising more than $2 to $60.20 as parts of the US dealt with unusually frigid weather that limited production. Elsewhere, the US Dollar treaded water in its recent ranges while Gold weakened. Treasury yield volatility spiked late in the week to levels not seen since last November, driving up the cost of rate caps and swaptions in the process.

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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.

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Yellen tips tax hikes to fund US infrastructure. Here we go. Secretary of the Treasury Janet Yellen – the ex-Fed Chief – reiterated her view that the risks of not going big on a coronavirus fiscal relief package from Congress far outweighs the costs. Yellen stated that should the package, which is expected to come in near $1.9 trillion, spark a surge in inflation, the Fed has the tools to deal with any upward price pressures. She said the Biden administration intends to introduce an infrastructure package later this year and that tax hikes will likely be part of the proposal, though she did not provide details.

What to Watch This Week: The days ahead are peppered with releases of Tier-1 economic data centered on the consumer, combined with important speeches from Fed officials.

The most important event is Fed Chair Powell’s two-day semi-annual testimony before Congress (Tuesday-Wednesday) where he is expected to acknowledge that the latest round of economic data resolutely signals that the economy has indeed shrugged off the winter doldrums, while also signaling that these encouraging developments fall far short of the threshold which could spur the Fed to rethink its stimulus exit timeline.

On the data front, data on consumer confidence (Tuesday) should come in higher, and may highlight, in combination with last week’s blowout retail sales data, that the gap between what consumers say and what they do is often vastly different. Data on personal income and spending (Friday) will likely come in higher than expected as part of the overtly positive retail sales data from last week, reflecting a solid increase in discretionary goods spending, specifically in services, such as restaurants, aided by the more than $130 billion in stimulus money distributed this month.

Big Picture: How long can the steady rise in long-term rates go on? With rate moves like we’ve seen of late, it’s a legitimate question. With the Fed seemingly firmly on the sidelines, probably a lot longer. That being said, financial markets led the Fed to rate-cut territory in 2019 like a dog on a leash, and with the improving outlook in its infancy, there is plenty of time for the Fed to see how things play out before it will need to make any hard decisions about taking away the punch bowl to temper the economic recovery, especially since the next round of massive fiscal stimulus hasn’t been unleashed. The Fed isn’t changing its policy stance anytime soon to stem the rise in long-term rates no matter what the economic data says. The question now: Is your debt portfolio prepared for a world of higher long-term rates?

Current Select Interest Rates:

Rate Cap & Swap Pricing:

LIBOR Futures:

Source: Bloomberg Professional

10-year Treasury:

Source: Bloomberg Professional