Treasury Yields Surge

The 10-year Treasury yield surged 13 basis points, the biggest one-day rally in months, on the first trading day of the year and despite no notable economic data or central bank speak, and the reason for the big move was that investors were positioning ahead of several events that could add to growth and inflation (and in doing so, hit bonds). But before we examine those two events, it’s important to return to Macroeconomics 101 and refresh the simplest (and in many ways the most important) definition of inflation: Too much demand chasing too few goods. We’ve seen that in real life.

“Too much demand” means people have a lot of money, and they do! The combination of 1) Forced savings from pandemic lockdowns, 2) Extra money from nearly two years of historical stimulus and 3) Surging asset prices (homes, boats, cars, etc.) and 4) Historic wage increases mean many Americans are as flush with cash as they’ve been, maybe ever. That has increased demand for virtually everything—because more people have money to spend.

“Too few goods” means people can’t get what they want, when they want it—and that causes price increases. This increase in demand has run full force into the worst supply chain breakdown since the global economy developed starting in the late 90s/early 2000s, and the net result is a reduction in the amount of goods available, and rising prices.

Similarly, due to a multitude of factors that includes stimulus and COVID isolation protocols, the amount of service labor has similarly been constrained, and that increases upward pressure on inflation (so inflation is coming from constrained goods and services supply).

Two events loom that could exacerbate this (meaning more demand/less supply).

The first is Omicron. Evidence continues to mount that Omicron will 1) Not be a material headwind on global growth and won’t delay rate hikes and 2) Will cause more supply chain disruptions and delays, and that could mean higher-for-longer inflation metrics. These could combine to make the Fed more hawkish.

The second is “Build Back Better”. While the Democrats failed to pass the bill in December, it could pass in early 2022. If it does, it will include additional stimulus and Federal spending— meaning more demand! That can meet with continued supply chain issues due to Omicron to further stoke inflation, which means a possibly more hawkish Fed and higher yields.

Treasury markets reflected this increased probability on the first trading day of the year, now that 2021 performance numbers were no longer a worry. More broadly, while Treasury yields have been very low, it’s important to step back and realize the performance of the 10-year Treasury yields last year did not match the fundamentals, and part of Monday’s move was a correction of that condition amidst possibly “pro-inflation” catalysts on the horizon.

Consider that in 2021:

• Inflation surged to 30-plus-year highs at more than double the Fed’s target.

• Global economic demand and growth surged back to pre-COVID levels.

• Unemployment collapsed to pre-pandemic levels (the best employment numbers in decades)

• The Fed signaled it was going to hike rates to combat inflation.

Despite that, the 10-year Treasury yield rose just 57 basis point and closed at 1.50%, well below the February 2021 highs. Now, it’s not that the market was “wrong” with yields in 2021—the market is never wrong, as there were headwinds on rising yields. But the 10-year yield at 1.51% to start 2022, amidst that macroeconomic backdrop, suggests one of two possibilities this year.

The macro backdrop could deteriorate and decline to match yields, or yields rise to match the macroeconomic backdrop. On the first trading day of the year, investors positioned for the former.

From a positioning standpoint, exposure to inflation and higher yields via financials and cyclical sectors remains an important part of balanced equity strategy as we start the year. Those sectors outperformed on Monday in response to higher yields, and if yields resume their march higher, these sectors could outperform growth and tech.