Yields Defy Inflation Expectations
Global uncertainty has dominated the direction of long-term interest rates recently.
Nominal Treasury yields have converged with breakeven rates, or market expectations for inflation (calculated from Treasury Inflation-Protected Securities yields). As shown in the LPL Chart of the Day, the difference between the 10-year Treasury yield and 10-year breakeven rate has fallen to the smallest spread in 16 months, hinting that bond investors may be underpricing the future pace of inflation.
“The disconnect between interest rates and inflation expectations is another sign to us that yields are too pessimistic for U.S. fundamentals,” said LPL Research Chief Investment Strategist John Lynch. “Fixed income investors globally have relied on U.S. debt this year for safety, yield, and liquidity.”
Recent economic reports support our perspective of moderate inflation. In April, the core Consumer Price Index (excluding food and energy prices) rose 2.1% year over year in April, while core personal consumption expenditures climbed 1.6% year over year in March. Consumer price growth has slowed, but neither gauge is at a worrisome level. Wages have also grown at a 3% year-over-year clip for the past several months.
At the same time, it’s tough to predict what will push the 10-year yield up in the near term. Global rates continue to slide amid trade and political uncertainty worldwide. U.S.-China trade tensions have escalated over the past two weeks, and a deal may not be as close as investors previously thought.
Still, we believe yields will ultimately respond to improving growth expectations and slightly higher inflation. A resolution in the U.S.-China trade dispute and stabilization in global markets could help ease buying in Treasuries and make way for the 10-year Treasury yield to potentially make a run at 3% by year end.
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