While further gains will be harder from here, indicators continue to point to a supportive backdrop for yields and the yield curve, with the latter historically tending to steepen through US elections

In our October monthly report (The Case for Banks – October 8th 2020) we discussed how even though the move to higher yields and a steeper yield curve had become consensus, these trends should persist into early next year.

On a pure total return basis, bonds have worked off some of their more extreme overboughtness, but remain overbought. Reversion to the mean (or an overshoot) would mean higher yields.

Charts Source: Bloomberg, Macrobond and Variant Perception

Moreover, our fair value model for US bonds continues to point to higher yields. It is not supposed to be a point forecast, but when the gap between the predicted value and actual yields is relatively stretched as it is today, then it suggests the direction of travel is for higher yields.

The Fed is unlikely to countenance yields going considerably higher, so it is currently difficult to see US 10y yields going far beyond 1% (currently they are 0.80%) without a significant amount of dip buying coming in.

Furthermore, the recent rise in yields has all been driven by term premium. With the Fed pinned at close to 0%, the market is finding it very difficult to price in higher rates at all, meaning the yield move has been driven entirely by a rise in term premium.

Charts Source: Bloomberg, Macrobond and Variant Perception

This indicates the move higher in rates is so far the “good” kind as far as equities are concerned, representing a marking up of growth expectations as the more pessimistic forecasts for growth look less likely to be realised, while at the same time the Fed is nowhere near kicking off a new hiking cycle. Higher term premium is generally consistent with a steeper yield curve, which is what we have seen so far.

The backdrop is supportive for a steeper yield curve at the moment – even more so if indeed a Blue Wave still transpires. A rising twin deficit is consistent with a steeper yield curve.

Charts Source: Bloomberg, Macrobond and Variant Perception

Moreover, looking at US elections back to 1980, the 2s10s yield curve tends to have a steepening bias just before, and after, an election.

Charts Source: Bloomberg, Macrobond and Variant Perception

This supportive backdrop for the yield curve increases the likelihood that the Fed will begin to re-emphasise yield curve control (YCC) as a potential new policy tool (or similar policies such as extending the weighted-average maturity of QE).

If the Fed goes down the route of YCC, they may opt to target the shorter end of the curve as the RBA in Australia has done. The RBA targets the cash rate vs the 3yr bond yield at 0%. But in Australia, other parts of the curve, eg 5s30s, have started to drift higher.

Charts Source: Bloomberg, Macrobond and Variant Perception

We posit that if the Fed went down the route of YCC, it would have difficulty in keeping the entire yield curve flat. If inflation expectations were to rise, even if the Fed is artificially repressing some parts of the curve, they are likely to show up somewhere, most likely in longer-term yields.

Longer-term inflationary risks have risen with the Fed’s new policy of average inflation targeting. As we have previously discussed, this is likely to lead to higher fixed-income volatility. Such a trend also points towards higher yields and a steeper yield curve as lenders require greater compensation for more uncertainty.