Coming into this year, we expected longer-maturity U.S. Treasury yields to rise, consistent with improving economic growth dynamics. That is indeed what we have seen, with the yield on the 10-year Treasury higher by 80 basis points (0.8%) year-to-date, and over 120 basis points (1.2%) since last year’s lows.
What we did not expect—at least not until the Democrats won two Senate seats in Georgia—was an additional nearly $2 trillion fiscal stimulus package on top of the super-accommodative Federal Reserve (Fed). The stronger economic growth outlook and resulting uptick in inflation expectations, which are key fundamental inputs into assessing Treasuries’ valuations, leads us to increase our year-end forecast for the 10-year Treasury yield to a range of 1.75% – 2.0%.
“The economic recovery continues to surprise to the upside and we think higher Treasury yields will be a result of that continued growth,” according to LPL Financial Chief Market Strategist Ryan Detrick.
Additionally, in our Outlook 2021: Powering Forward, we took a look at how Treasury yields did after large declines, which we certainly had as of the end of the first quarter in 2020. Here we are a year later and the outcome is well aligned with history. As seen in the LPL Research Chart of the Day, over the six prior large declines since 1990, the 10-year yield climbed an average of 0.92 percentage points after a large decline; this time the number was just a little higher at just above a full percentage point. What happened next historically? In the next quarter, yields continued to rise, on average, but fell over the following two quarters to get about back to a little above where they were after a year. If that holds true this time, it’s a good fit with our updated forecast range of 1.75–2.0%.
Yields may temporarily eclipse 2.0% in the short-term, as inflation readings pick up and economic data continues to show material improvements. However, we still believe there are structural headwinds to sustained, outsized inflation levels that should limit further sell-offs in Treasuries and bring yields back in-line with our fundamental assessment by year end (read more on our inflation views here). Moreover, given the continued search for income, yield levels significantly above 2.0% would likely represent an attractive entry point to both foreign and domestic investors, assuming no material changes to the growth and inflation outlook.
While we are updating our year-end Treasury yield forecast, our preference for less interest-rate sensitive fixed income investments has not changed. Additionally, we still believe an underweight to fixed income relative to targets within a diversified asset allocation makes sense at this time.
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