The recent surge in U.S. Treasury yields is looking very close to a peak.
Data this week showing that the world's largest economy is improving may give another temporary lift to yields, but it's unlikely that the run will stretch far, in light of the Federal Reserve's concern about U.S. unemployment.
The yield on 10-year U.S. Treasury notes rose to 2.4 per cent in the second half of March, up from below 2 per cent at the end of February, as investors demanded higher rates of return for buying the government debt. Although some of the increase in yields had tailed off by the end of last week, it's clear that a brightening economic picture in the U.S. is giving investors a bigger appetite for risk and less desire for the perceived haven of U.S. government debt.
The yield on the world's bellwether fixed-income security hit a low last September of 1.7 per cent. Between last November and the beginning of March, it barely got above 2 per cent. But last month, upbeat reports on jobs, retail sales, manufacturing and personal spending convinced many investors that the U.S. recovery is firmly in gear. The yield on 10-year Treasuries climbed 27 basis points in the first quarter, the biggest quarterly gain in more than a year.
As yields rose, Goldman Sachs told investors that it was time to move from bonds to stocks, where total returns (i.e. capital gains and yields) would likely be higher.
The Street is expecting Treasury yields to rise further this year and bond prices, which move inversely to yields, to fall. But the rise will be much more gradual than the jump we saw in March. A survey of financial companies by Bloomberg News found the average forecast for 10-year yields is 2.5 per cent by the end of the year.
Paul Dales, senior U.S. economist at Capital Economics, points out that the 10-year Treasury yield is essentially an average of the official interest rates expected by the market over the course of the decade to come. "That means Treasury yields are unlikely to increase significantly until the Fed gets closer to raising interest rates from near zero," he said.
Fed Chairman Ben Bernanke gave a relatively cautious outlook for the U.S. economy last week, and indicated that the central bank's plan of keeping rates "exceptionally low" at least through 2014 remains intact.
"Until the current 8.3 per cent unemployment rate falls meaningfully toward 6 per cent, Bernanke seems keen on keeping the monetary pedal to the metal. And, should anything slow the rate of decline in joblessness, then Bernanke appears open to pushing the pedal through the floor to drive away this bête noire," noted Sal Guatieri, senior economist with BMO Nesbitt Burns Inc.
This week will see the release of several key numbers – March's ISM manufacturing index, February's factory orders and last month's employment figures. Economists expect them to paint a relatively upbeat picture. For instance, the U.S. is expected to have added 210,000 jobs in March, for a fourth consecutive month of healthy gains above the 200,000 threshold.
However, any disappointment in the data could send investors back to Treasuries. Peter D'Antonio, head of U.S. economic forecasting at Citigroup Inc., warns that the optimistic employment picture of the last few months has likely been padded by unseasonably warm weather.
"We look for a pullback in payroll gains in March from the outsized increases of the previous three months," he said, noting that the labour force has swelled by more than 700,000 in the past three months.
Indeed it's the unusual state of the job market that had Mr. Bernanke recently standing by the Fed's 2014 target. That prompted Mr. Dales to comment that historically, the yield on 10-year Treasuries tends to begin climbing about seven months before the Fed starts to hike interest rates.
"If we're right in thinking that rates won't be raised until the end of 2014, then a sustained and significant rise in Treasury yields won't be seen until early or mid-2014," he said.