The recent surge in longer-term Treasury yields has been the biggest story in financial markets these days.
On October 3, the 10-year yield jumped 12 basis points (0.12%), its biggest daily gain since the day after the 2016 presidential election, after Federal Reserve Chair Jerome Powell commented on the U.S. economy’s “remarkably positive” outlook. On Friday, the 10-year yield rose to 3.23%, its highest level since May 2011.
Powell’s optimism and economic momentum have been a boon for longer-term yields, but we think these rates have limited upside in the short-term. As shown in the LPL Chart of the Day, the 10-year yield is now near the upper end of our year-end target of 2.75%-3.25%, which we initially projected in our 2018 Outlook: Return of the Business Cycle.
“Longer-term rates have risen with growth expectations, but inflationary pressures remain manageable,” said LPL Research Chief Investment Strategist John Lynch. “We think Treasury yields may experience only modest increases through the end of this year and into next year.”
We think the biggest signal of a breather for longer-term yields has been manageable inflationary pressures, as longer-term yields tend to fluctuate with inflation expectations. We view wage growth as an important economic indicator for inflation, since wages represent up to 70% of business costs. The September jobs report showed average hourly earnings grew 2.8% year over year last month, well below the 4% wage growth that has historically led to aggressive interest-rate increases and restricted economic output. Market expectations for inflation have also lagged the recent jump in rates. Breakeven inflation rates, the difference between the yields of nominal Treasuries and those of Treasury Inflation Protected Securities (TIPS), have yet to break above highs reached earlier this year. Updated Consumer Price Index (CPI) and Producer Price Index (PPI) data are due out later this week, so we’ll be looking for clues on inflation in these reports.
Yields around the world, though rising, remain at relatively low levels, so we expect global fixed income investors to continue turning toward Treasuries for diversification, valuation, liquidity and income.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Diversification does not protect against market risk.
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