Surging Bond Yields 2018’s Twist

January 31, 2018

It took more than a year to happen, but interest rates are finally rising again. On Monday, the U.S. 10-year Treasury yield leapt to as much as 2.73%, the loftiest level in nearly three years and decisively above of last year's high of 2.64%.

In turn, bond ETFs tied to the 10-year, such as the iShares 7-10 Year Treasury Bond ETF (IEF), tumbled (bond prices and yields move inversely). IEF is down 2% this year, while the broader iShares Core U.S. Aggregate Bond ETF (AGG), which holds Treasuries and other investment-grade bonds, is down 1%.

 

US 10-Year Treasury Yield

 

 

10-Year Outpacing 2-Year

The latest jump in interest rates was in many ways expected. Since the 10-year Treasury yield's previous peak in December 2016, the Federal Reserve hiked interest rates four times, and by 1 full percentage point; stocks surged by more than 25%; and the unemployment rate hit an 18-year low―all factors that typically put upward pressure on yields.

Short-term interest rates have been responding to these cues; long-term rates are just starting to pay attention. The two-year Treasury yield increased by 0.67% in 2017, at the same time that the 10-year yield fell by 0.04%. This year, the 10-year yield is outpacing the two-year yield with a gain of 0.30% compared with 0.24%.

Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management, says that, up until now, the long end of the curve was being suppressed by geopolitical fears, especially related to North Korea.

"The apparent détente with South Korea has helped push yields higher," he said. "The market narrative has also shifted toward answering when—rather than whether—the ECB and Bank of Japan will start to let the long end of their curves move higher."

Yield Curve 'Spring Loaded'

Now that rates are moving up, it's natural to ask, how high can they go? A consensus of 64 Wall Street analysts compiled by Bloomberg sees the 10-year yield reaching 2.86% and the two-year yield reaching 2.41% in the fourth quarter.

Jacobsen, who believes the Fed will hike another two or three times this year, sees little resistance to the 10-year yield getting to 3%, but doesn't envision it reaching 4% in 2018. He also sees the long end of the curve moving up faster than the short end.

"We think the yield curve could be spring-loaded. It’s compressed with the short end moving up and long end staying low. Rather than signaling an economic slowdown, we think it could aggressively steepen," he said.

 

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