The 2-year Treasury yield has had a strong move higher over the past few months. After surpassing the dividend yield of the S&P 500 Index in October, it hit another threshold on Thursday as it closed above the 2.0% level for the first time since September 2008, as shown in the chart below. What caused this recent run up?
There are a number of reasons for the move higher in short-term yields, but three of the biggest drivers are likely:
- Federal Reserve (Fed) rate hike expectations
- Anticipation of increased Treasury issuance
- Potential for higher inflation
We believe that inflation is a critical piece of the puzzle, as the core reading in last week’s Consumer Price Index (CPI) report came in above expectations, at 1.8% year over year. This is still below the Fed’s 2.0% target, but market expectations of future inflation, as measured by 10-year breakeven inflation (the difference between the yield on 10-year Treasuries and 10-year Treasury Inflation-Protected Securities), as well as the Fed’s 5-year, 5-year forward inflation forecast (a forecast of 5-year inflation, 5 years from now) are both just above 2.0% currently.
We think the Fed will remain gradual with rate hikes despite the inflationary pressures that are likely to emerge this year. Wage inflation has to rise to a greater degree than what current trends are indicating before levels threaten to force the Fed’s hand. Per John Lynch, Chief Investment Strategist: “Regarding inflation, we remain focused on wages, which on average represent more than two-thirds of business’ costs. If they’re not rising at a threatening pace, it’s hard to have a sustainable inflationary threat. Currently, wage growth is tracking to 2.5% year over year, but historically levels above 4.0% have been indicative of more persistent inflation and an aggressive Fed.”
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Past performance is no guarantee of future results.
The economic forecasts set forth in the presentation may not develop as predicted.
Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Federal Reserve (Fed) is the central bank of the United States. Its unique structure includes a federal government agency–the Board of Governors–in Washington, D.C., and 12 regional reserve nanks (Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco, and St. Louis).
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
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