Dollars and Sense

Bond Yields: What’s Up, Doc? 

Beata Caranci, SVP & Chief Economist | 416-982-8067

James Orlando, CFA, Senior Economist | 416-413-3180

Date Published: January 21, 2020

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Highlights

  • Long-term bond yields have risen alongside improved prospects for the economic outlook.
  • The gradual upward trend that started several months ago developed a tailwind following the Georgia Senate runoff and President Biden’s significant fiscal package proposal.
  • Embedded in yields is a repricing of market inflation expectations, which shot up from depressed levels in early-2020 to more than 2% today. 
  • The yield curve will continue to steepen this year and next as markets pull forward pricing for the policy rate paths of the Federal Reserve and Bank of Canada.
Chart one shows the level of inflation expectations with moments in time highlighted with arrows. The upward trend from the stock market sell-off of early-2020 is apparent and supported by the Fed's new mandate in August, the U.S. election in early-November, and the repricing of fiscal policy in late-November. The first few weeks of 2021 have been marked by a near 20 basis point jump in government bond yields in the U.S. and Canada. The U.S. 10-year Treasury yield has pushed through the 1% psychological threshold to sit at 1.10%, whereas the Canadian equivalent currently trades at a yield of 0.84%. This is an extension of an upward trend that started in August 2020. Since that time, the outlook for economic growth has improved, pushing the peak-uncertainty period to the background. The same can be said for future inflation, prompting the repricing of bond yields. This dynamic should continue to press yields higher in the coming months.

Fiscal Policy: Of course, you realize this means war on bonds! 

Optimism towards more fiscal stimulus has been the latest contributor to the move higher in government bond yields. With Democrats gaining influence over the Senate, a near-$2 trillion package has been put on the table by President Biden. This comes on top of a $900 billion bipartisan deal struck in the final days of last year to support struggling American households and businesses. A government safety net firmly in place improves consumer sentiment, let alone the momentum shift that will naturally occur as improved household finances dovetail with fewer business restraints as vaccine distribution builds within the population in the coming quarters. 

Higher growth expectations come with higher inflation expectations. In Chart 1, we show that market-based inflation expectations have continued to rise since the worst of the pandemic-induced sell-off in March 2020. After falling to less than 0.9% at that time, market participants now see inflation consistent with the Fed’s target, at 2.1%. 

Chart two shows the level of the U.S. 10-year Treasury and the U.S. 10-year overnight index swap in percent. Both series were declining from January 2020 to August 2020. After that, they have been increasing together. Likewise, this earlier rebound in inflation is paralleled in rate hike expectations. As we show in Chart 2, market pricing for the Fed’s policy rate a decade from now is starting to move up. After hitting rock bottom in August 2020, the expected policy rate has increased approximately 60 basis points. It is no coincidence that the U.S. 10-year Treasury yield has paralleled this movement. 

 

Despite the recent swift repricing, the policy rate has more room to go. The market is expecting the fed funds rate to be only 0.9% in the long run. In contrast, Federal Reserve members see it closer to 2.5%. Our expectation is right in between those two worlds, where we have penciled in the effective rate at 1.85%. This has two implications. The first is that it would still leave a modestly negative real rate that can hardly be considered as restrictive. The second is that the UST 10-year yield will need to rise further, as markets gradually price a higher endpoint for the fed funds rate. We draw the same conclusion for Canada, where an end-target policy rate of 1.75% should correspond with long-term bond yields of around 2%. 

More Curve Steepening Ahead

Chart three shows the spread of the U.S. 10-year and U.S. 2-year Treasury yields from 1987 to 2021. The series appears to bottom right before recession and increase during recession.

This shift in central bank expectations doesn’t occur overnight. Until the central bank hints at the road map, the yield curve will continue to steepen with the short end pinned to a floor. In mid-December, the Fed maintained a commitment to keep its policy rate at effectively zero through 2023. This commitment is not written in stone, however. It is based on developments and assumptions at that point in time. Higher economic growth expectations from a much larger injection of fiscal stimulus, combined with a successful vaccine rollout could pull forward the timing of a rate hike. Even so, any pull-forward in the timing would likely be a modest adjustment of one-to-two quarters in the absence of sustained build-up in inflationary pressures.

Since the short-end of the curve reflects the agreement between market participants and the central bank, the spread between the UST 10-year and UST 2-year yield reached a three year high of 90 basis points last week. This steepening of the yield curve is exactly what investors should expect at this point in the economic cycle (Chart 3). Just like in past cycles, after reaching a trough right before the recession, the yield curve pivots well ahead of the exit of a cycle, steepening even during the worst of the pandemic. 

The Foreign Exchange Impact

The shift in economic risks has taken some of the shine off the U.S. dollar. After peaking in late-March 2020, the greenback has since depreciated approximately 12%. Though much of this move was an unwind of the pandemic-induced flight-to-safety trade, the sell-off has gone even further. The dollar is now trading approximately 3% below its pre-pandemic level. 

The recent greenback weakness has a lot to do with the nature of the global economic recovery. Economies that are leveraged to the boom in manufacturing have seen their currencies outperform. Just take a look at China. It has flexed its economic prowess, being the only major economy in the world to achieve positive GDP growth over 2020. At the same time, the US economy is 3% below last year’s GDP level. China’s dominance in manufacturing exports contributed to the more than 10% appreciation of its currency versus the U.S. dollar from its 2020 low. 

With China’s success has come renewed demand for raw materials. Commodity exporting countries like Canada and Australia have benefited from the lift in prices for raw materials, like copper and iron ore. Even though both Canada and Australia are still in the process of recovering, the demand for their exports has caused their currencies to appreciate to levels consistent with their long-term fair value. 

This isn’t to say there isn’t more upside. Take the case of the Canadian dollar. Though it has appreciated with the non-energy commodity story, further upside can occur on the back of renewed energy demand. The vast majority of energy consumption comes from mobility – driving cars or flying in planes. With mobility likely to increase in 2021, demand for energy could push prices even higher. The Canadian dollar would likely appreciate along with it.

Bottom Line

Optimism towards the economic recovery has raised expectations for future growth and inflation. The improved outlook has pushed up inflation expectations just north of 2% and caused a partial repricing of the Federal Reserve’s policy path. Consequently, longer-term bond yields have continued to rise. We think there is more to go as the economic recovery solidifies over the coming months. The success of the vaccine deployment and its efficacy will be huge in determining whether the economic forecasts become reality. Over the last few months, the changes to the forecast have favored a more rapid economic recovery. For the sake of the economy, we hope it continues to surpass our expectations.

Tables

Interest Rate Outlook

F: Forecast by TD Economics, January 2021; Forecasts are end-of-period. Source: Bloomberg, Bank of Canada, Federal Reserve.
Interest Rates Spot Rate 2020 2021 2022
Jan-20 Q1 Q2 Q3 Q4 Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
CANADA                          
Overnight Target Rate  0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25
3-mth T-Bill Rate  0.06 0.21 0.20 0.12 0.06 0.05 0.10 0.15 0.20 0.20 0.20 0.20 0.20
2-yr Govt. Bond Yield  0.16 0.42 0.28 0.25 0.20 0.20 0.25 0.30 0.30 0.30 0.35 0.40 0.50
5-yr Govt. Bond Yield  0.43 0.60 0.36 0.36 0.39 0.45 0.55 0.70 0.80 0.95 1.05 1.15 1.25
10-yr Govt. Bond Yield  0.83 0.71 0.52 0.57 0.67 0.85 1.00 1.15 1.30 1.40 1.55 1.65 1.70
30-yr Govt. Bond Yield  1.46 1.30 0.99 1.11 1.21 1.45 1.55 1.65 1.75 1.85 1.95 2.05 2.15
10-yr-2-yr Govt Spread 0.66 0.29 0.24 0.32 0.47 0.65 0.75 0.85 1.00 1.10 1.20 1.25 1.20
U.S.                         
Fed Funds Target Rate  0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25
3-mth T-Bill Rate  0.08 0.11 0.16 0.10 0.09 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10
2-yr Govt. Bond Yield  0.13 0.23 0.16 0.13 0.13 0.15 0.18 0.20 0.20 0.20 0.25 0.30 0.35
5-yr Govt. Bond Yield  0.44 0.37 0.29 0.28 0.36 0.50 0.60 0.70 0.80 0.90 0.95 1.05 1.15
10-yr Govt. Bond Yield  1.08 0.70 0.66 0.69 0.93 1.10 1.25 1.40 1.50 1.55 1.60 1.65 1.70
30-yr Govt. Bond Yield  1.83 1.35 1.41 1.46 1.65 1.85 1.95 2.05 2.15 2.20 2.25 2.30 2.35
10-yr-2-yr Govt Spread 0.95 0.47 0.50 0.56 0.80 0.95 1.07 1.20 1.30 1.35 1.35 1.35 1.35
CANADA - U.S SPREADS                          
Can - U.S. T-Bill Spread -0.02 0.10 0.04 0.02 -0.03 -0.05 0.00 0.05 0.10 0.10 0.10 0.10 0.10
Can - U.S. 10-Year Bond Spread -0.25 0.01 -0.14 -0.12 -0.26 -0.25 -0.25 -0.25 -0.20 -0.15 -0.05 0.00 0.00

International Interest Rates Outlook

F: Forecast by TD Economics, January 2021; Forecasts are end-of-period. Source: Bloomberg.
 Interest Rates Spot Rate 2020 2021 2022
Jan-20 Q1 Q2 Q3 Q4 Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Germany                          
ECB Deposit Rate -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50
3-mth T-Bill Rate  -0.59 -0.71 -0.56 -0.62 -0.77 -0.60 -0.60 -0.60 -0.60 -0.60 -0.60 -0.60 -0.60
2-yr Govt. Bond Yield  -0.71 -0.70 -0.70 -0.70 -0.72 -0.65 -0.60 -0.55 -0.49 -0.46 -0.42 -0.36 -0.28
5-yr Govt. Bond Yield  -0.72 -0.66 -0.70 -0.71 -0.74 -0.65 -0.55 -0.50 -0.44 -0.41 -0.37 -0.31 -0.23
10-yr Govt. Bond Yield  -0.53 -0.47 -0.46 -0.52 -0.58 -0.50 -0.40 -0.35 -0.29 -0.26 -0.22 -0.16 -0.08
30-yr Govt. Bond Yield  -0.12 0.02 0.00 -0.10 -0.16 -0.15 -0.05 0.00 0.06 0.09 0.13 0.19 0.27
10-yr-2-yr Govt Spread 0.18 0.23 0.24 0.18 0.14 0.15 0.20 0.20 0.20 0.20 0.20 0.20 0.20
United Kingdom                  
Bank Rate 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10
3-mth T-Bill Rate  0.01 0.18 0.01 0.00 -0.06 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
2-yr Govt. Bond Yield  -0.12 0.12 -0.08 -0.03 -0.06 -0.05 -0.05 0.00 0.05 0.10 0.15 0.15 0.20
5-yr Govt. Bond Yield  -0.03 0.21 -0.05 -0.06 -0.09 0.00 0.05 0.10 0.15 0.20 0.25 0.25 0.30
10-yr Govt. Bond Yield  0.30 0.35 0.17 0.23 0.20 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70
30-yr Govt. Bond Yield  0.88 0.82 0.64 0.78 0.75 0.90 0.95 1.00 1.05 1.10 1.15 1.20 1.25
10-yr-2-yr Govt Spread 0.42 0.23 0.25 0.26 0.26 0.40 0.45 0.45 0.45 0.45 0.45 0.50 0.50

Foreign Exchange Outlook

F: Forecast by TD Economics, January 2021; Forecasts are end-of-period. Source: Federal Reserve, Bloomberg.
Currency Exchange
rate
Spot Price 2020 2021 2022
Jan-20 Q1 Q2 Q3 Q4 Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Exchange rate to U.S. dollar                          
 Chinese Yuan CNY per USD 6.47 7.08 7.07 6.79 6.53 6.50 6.55 6.60 6.65 6.70 6.75 6.80 6.80
 Japanese yen JPY per USD 104 108 108 106 103 104 104 103 103 102 102 101 101
 Euro USD per EUR 1.21 1.10 1.12 1.17 1.22 1.20 1.21 1.22 1.24 1.25 1.26 1.26 1.26
 U.K. pound USD per GBP 1.37 1.25 1.24 1.29 1.37 1.36 1.37 1.37 1.38 1.39 1.39 1.40 1.40
 Swiss franc CHF per USD 0.89 0.96 0.95 0.92 0.88 0.89 0.90 0.91 0.92 0.93 0.94 0.95 0.96
 Canadian dollar CAD per USD 1.26 1.41 1.36 1.33 1.28 1.27 1.25 1.24 1.23 1.24 1.25 1.25 1.26
 Australian dollar USD per AUD 0.77 0.61 0.69 0.72 0.77 0.77 0.77 0.76 0.75 0.74 0.73 0.73 0.73
 NZ dollar USD per NZD 0.72 0.60 0.65 0.66 0.72 0.72 0.72 0.71 0.69 0.68 0.67 0.67 0.67
Exchange rate to Euro                          
 U.S. dollar USD per EUR 1.21 1.10 1.12 1.17 1.22 1.20 1.21 1.22 1.24 1.25 1.26 1.26 1.26
 Japanese yen JPY per EUR 125 118 121 124 126 124 126 127 127 128 128 128 127
 U.K. pound GBP per EUR 0.89 0.89 0.91 0.91 0.90 0.88 0.89 0.89 0.90 0.90 0.90 0.90 0.90
 Swiss franc CHF per EUR 1.08 1.06 1.06 1.08 1.08 1.07 1.09 1.12 1.14 1.16 1.18 1.19 1.21
 Canadian dollar CAD per EUR 1.53 1.56 1.53 1.56 1.56 1.53 1.52 1.52 1.53 1.55 1.56 1.58 1.59
 Australian dollar AUD per EUR 1.56 1.79 1.63 1.64 1.59 1.56 1.57 1.61 1.65 1.69 1.72 1.72 1.73
 NZ dollar NZD per EUR 1.69 1.85 1.74 1.77 1.70 1.67 1.68 1.72 1.79 1.84 1.87 1.88 1.88
Exchange rate to Japanese yen                          
 U.S. dollar JPY per USD 104 108 108 106 103 104 104 103 103 102 102 101 101
 Euro JPY per EUR 125 118 121 124 126 124 126 127 127 128 128 128 127
 U.K. pound JPY per GBP 141 134 133 136 141 141 142 142 142 142 142 142 141
 Swiss franc JPY per CHF 116.4 111.7 113.8 114.9 116.7 115.9 115.3 113.6 111.9 110.2 108.6 107.0 105.4
 Canadian dollar JPY per CAD 82.0 76.1 79.2 79.2 80.9 81.4 83.0 83.4 83.4 82.6 81.8 80.9 80.1
 Australian dollar JPY per AUD 80.2 66.0 74.3 75.6 79.5 79.7 80.0 78.6 77.2 75.8 74.4 74.0 73.6
 NZ dollar JPY per NZD 74.2 64.1 69.5 69.8 74.2 74.5 74.8 73.4 71.0 69.6 68.3 67.9 67.6
Exchange rate to Canadian dollar                          
 U.S. dollar USD per CAD 0.79 0.71 0.74 0.75 0.78 0.79 0.80 0.81 0.81 0.81 0.80 0.80 0.79
 Japanese yen JPY per CAD 82.0 76.1 79.2 79.2 80.9 81.4 83.0 83.4 83.4 82.6 81.8 80.9 80.1
 Euro CAD per EUR 1.53 1.56 1.53 1.56 1.56 1.53 1.52 1.52 1.53 1.55 1.56 1.58 1.59
 U.K. pound CAD per GBP 1.73 1.76 1.68 1.72 1.74 1.73 1.71 1.70 1.70 1.72 1.74 1.75 1.76
 Swiss franc CHF per CAD 0.70 0.68 0.70 0.69 0.69 0.70 0.72 0.73 0.75 0.75 0.75 0.76 0.76
 Australian dollar AUD per CAD 1.02 1.15 1.07 1.05 1.02 1.02 1.04 1.06 1.08 1.09 1.10 1.09 1.09
 NZ dollar NZD per CAD 1.10 1.19 1.14 1.14 1.09 1.09 1.11 1.14 1.18 1.19 1.20 1.19 1.19

Global Stock Markets

*Weighted equity index including both developed and emerging markets. Source: Bloomberg, TD Economics.
Major Market Indexes Price 30-Day YTD 52-Week 52-Week
Jan-20 % Chg. % Chg.  High Low
S&P 500 3,852 3.8 2.6 3,852 2,237
S&P/TSX Composite 18,015 2.7 3.3 18,042 11,228
DAX 13,921 2.1 1.5 14,050 8,442
FTSE 100 6,740 3.2 4.3 7,651 4,994
Nikkei 28,523 6.6 3.9 28,698 16,553
MSCI AC World Index* 661 3.3 2.3 664 384

Commodity Price Outlook

F: Forecast by TD Economics, January 2021; Forecast are period averages; E: Estimate. Source: Bloomberg, USDA (Haver).
Commodity  Price 52-Week 52-Week 2020 2021 2022
Jan-20 High Low Q1 Q2 Q3 Q4 Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Crude Oil (WTI, $US/bbl) 53 59 -38 46 28 41 42 51 52 53 53 54 54 55 55
Natural Gas ($US/MMBtu) 2.60 3.04 1.35 1.91 1.71 1.99 2.53 2.80 2.70 2.60 3.00 3.10 2.90 2.80 3.15
Gold ($US/troy oz.) 1871 2064 1471 1582 1708 1909 1874 1875 1850 1850 1825 1800 1775 1750 1725
Silver (US$/troy oz.) 25.85 29.13 11.98 16.90 16.38 24.34 24.45 25.00 24.50 24.50 23.50 23.25 23.00 22.75 22.50
Copper (cents/lb) 361 370 210 255 243 296 326 360 340 330 324 319 315 312 310
Nickel (US$/lb) 8.26 8.29 4.94 5.76 5.53 6.45 7.24 7.60 7.45 7.40 7.38 7.35 7.37 7.05 7.05
Aluminum (Cents/lb) 89 94 66 77 68 77 87 87 86 84 81 78 78 75 75
Wheat ($US/bu) 7.53 7.53 5.75 6.60 6.46 6.36 6.84 7.45 7.35 7.25 7.15 7.10 7.05 6.95 6.90

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