It may be a year or more before the end of the recession is officially called, but gauging from the growth we’ve seen since April, it may already be over. If that’s true, it’s a good time to take a look at what US Treasury yields do early in a new economic cycle. As shown in the LPL Chart of the Day, in the last seven recessions, dating back to 1970, the difference between the 10-year Treasury and 3-month Treasury yield, referred to as a yield spread, at peak has been at least 2% every time—and above 3% in the last four recessions. (Looking at the spread between the 10-year and the 3-month Treasury makes it easier to compare times when the absolute rate level was different.)
“The four scariest words in market forecasting are ‘this time it’s different,’” said LPL Financial Chief Market Strategist Ryan Detrick. “But with the Bloomberg-surveyed economists’ consensus for the 10-year Treasury yield at just 1.2% for the end of 2021, the consensus view is that bond yields will behave differently coming out of this recession than they have in the past.”
The 3-month Treasury yield is unlikely to move much over the next year, with the Federal Reserve’s (Fed) updated policy framework allowing the Fed to keep rates lower for even longer. As long as the Fed’s policy rate is near zero, the 3-month Treasury yield is unlikely to push much over 0.25%, and it has generally been lower.
For example, let’s say it hovers around 0.1%, just to get a lowball estimate on where rates may go. Using the flattest of all the early expansion peaks, a 2.41% spread in 1970 would still give you a 10-year Treasury yield forecast of around 2.5%, nearly double the current forecast. So what are economists seeing?
- Global growth may remain muted. Prior to COVID-19, global growth was already persistently more tepid than it had been in prior decades. While pent-up demand may lead to temporarily elevated growth, long-term factors weighing on economic growth from before the recession are still in play, such as demographic headwinds and weak productivity growth. Also, the economic disruption from COVID-19 may have done some structural damage to the economy that will not be repaired easily.
- Inflationary pressure may be limited. Central banks have spent the last decade trying to give inflation a modest boost with little effect. While the scope of both monetary and fiscal stimulus leaves some room for an unexpected pickup in inflation down the road, spare capacity and slack in the labor market may keep inflation limited.
- Central banks are still active. Central banks continue to purchase bonds to help limit the increase in longer-term bonds yields.
- US yields are still attractive to global investors. If US yields climb relative to other international developed economies, Treasuries will become more attractive to international investors, potentially helping to limit additional increases. If the US dollar falls, however, some of this benefit may be lost.
All of these points have merit, and we also anticipate less steepening than we’ve seen in the past. Nevertheless, our rate outlook for 2021 sits above consensus. While we still see a historically flat post-recession yield curve peak, history still carries some weight, and the more upside we potentially get to economic expectations, the more history may be our guide. Overall, we’re targeting a 10-year Treasury yield of 1.25–1.75% in 2021, with a bias toward the lower end.
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