Interest rates will continue to rise, but don’t blame it all on inflation, economists say

Shoppers are seen wearing masks while shopping at a Walmart store in Bradford, Pennsylvania, July 20, 2020.

Brendan McDermid | Reuters

Interest rates are expected to continue their upward march, but for now they’re not expected to get high enough to harpoon the stock market.

Treasury yields have been rising quickly in the last week, and the benchmark 10-year yield has been on a tear – reaching 1.33% in the early morning hours Wednesday before retreating below 1.30%.

Yields move opposite price, and the 10-year has risen from about 1.15% just a week ago to levels that are close to where they were when the pandemic started hitting the economy last February.

The 10-year is key to the economy, since it impacts mortgages and other consumer and business loans.

Bond strategists say the move in yields has opened the door for a higher move, and a next logical target for the 10-year is 1.5%. The yield is unlikely to go much higher in the near term unless inflation picks up or there is a signal from the Fed that it is ready to tighten policy, which is highly improbable.

“I think it’s reflective of economic conditions, which is why other financial assets, like equities, aren’t taking it too badly,” said Jim Caron, head of global macro strategy at Morgan Stanley Investment Management.

“The thing is you ain’t seen nothing yet,” he said. “That’s with a $600 stimulus check. What about with a $1,400 stimulus check in hand?”

Improvement in the data

The Treasury market has been pricing in a more aggressive fiscal stimulus program from the Biden administration than many analysts had initially expected.

The proposed $1.9 trillion package winding its way through Congress may not be reduced by much. The package includes a $1,400 payment to individuals, on top of the $600 they received in early January.

Aside from the jobs report, the streak of recent data has shown improvement.

January retail sales, reported Wednesday, rose 5.3%, versus forecasts of 1.2% and following a decline in December.

The producer price index also rose sharply, up 1.3%, the most since 2009 in January as the cost of goods and services jumped. That suggests inflation is beginning to rise for manufacturers and can be a forewarning for higher consumer prices.

JPMorgan economists estimate the rise in the producer price index translates to higher forecast of a 1.7% increase in year-over-year personal consumption expenditures, the Fed’s preferred inflation measure.

The thing is you ain’t seen nothing yet. That’s with a $600 stimulus check. What about with a $1,400 stimulus check in hand?

Jim Caron

head of global macro strategy at Morgan Stanley Investment Management

The so-called PCE measures the changes in the cost of goods and services purchased by consumers.

“If this forecast for core PCE inflation is realized, it would be the firmest monthly increase since January 2007 while keeping the year-ago core PCE rate below the FOMC’s 2% inflation target,” the JPMorgan economists wrote, referring to the Federal Open Market Committee.

Even with the better data, the 10-year yield on Wednesday traded at about 1.29% after the early morning move to highs. Strategists said buyers were drawn in at around 1.30%, and the 10-year move may now slow or consolidate before another step up.

The strong data did cause economists to raise their views on growth.

Goldman Sachs economists upped their tracking estimate for first quarter gross domestic product growth to 6% from 5%, and Morgan Stanley economists raised their tracking forecast to 7.5%.

“Stimulus checks are coming, jobs are coming back. We think this is all going to happen as Covid numbers start to fall,” said Caron of Morgan Stanley.

“We’re still going to get that $1,400 check,” he said. “Plus, there’s pent-up demand. The party’s just getting started.”

Market prices in more inflation

The jumpstart to the economy has some investors worried that another big stimulus package will be igniting inflation and leave the U.S. struggling under a mountain of debt.

But Caron does not think the market is responding to that, and the stimulus is a jolt needed to fill the output gap created when the economy fell off a cliff last spring. He also does not expect inflation to be a problem.

The market, however, is beginning to price in more inflation. The 5-year breakeven, a market-based inflation instrument, was reflecting the view Wednesday that consumer inflation will average 2.37% over the next five years.

“You can take your pick whether it’s [the yield] going up with the stimulus or the economy and now the stimulus is actually impacting the economy. We’ve got stimulus already done which is making people spend, and stimulus to come which will spur more spending,” said Michael Schumacher, head of rate strategy at Wells Fargo Securities. “Inflation has been a talking point for the last few weeks.”

Economists expect inflation to perk up in the spring, along with higher prices from pent-up demand. However, they don’t expect the increase to be sharp enough for the Fed to engage on policy.

Ed Hyman, chairman of Evercore ISI, said on Wednesday that 2022 growth looks stronger and above trend, due to stimulus.

He said he was now expecting 3% growth in 2022, after 7.8% growth in 2021. However, Hyman’s view of inflation is still fairly tame. “The core PCE deflator is likely to increase 2.25% y/y in both 2021 and 2022, elevated but not significantly,” he wrote.

Hyman expects the 10-year yield to reach 2% this year and 2.5% next year.

“Probably the most important point here is that we’re in the early stages of a new expansion that’s likely to last at least through 2025,” he wrote in a note.

Strategists say rates should not rise too much with the Fed’s low rate policy and its bond buying program.

The Fed Wednesday reaffirmed its concerns about the economy and its plans to stay on hold for the foreseeable future, in the minutes from its last meeting.

“The December spending legislation assured the economy of more fiscal support, as did the incoming Biden administration’s release of its economic recovery proposals, which brightened the broader discussion of the outlook in the minutes, but Chair [Jerome] Powell’s press conference made clear the economy is not out of the woods yet,” said Bob Miller, head of Americas fundamental fixed income at BlackRock.

“And subsequent comments from other FOMC meeting participants reflect that now unified communications; essentially that ‘it’s too soon to talk about tapering’ the asset purchases,” Miller said.

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