The new year kicked off with a sharp rise in Treasury bond yields, despite unprecedented political turmoil and signs that the economic recovery is slowing. In the first 10 trading days of the year, 10-year Treasury yields rose sharply, and the yield curve1 steepened to its highest level since 2017—moves that are typically seen when the economy is expanding at a healthy clip. In many ways, it appears that the market is disconnected from the current state of the economy and politics.

Bond yields reflect that the market is focused on the outlook for stronger growth and potential inflation down the road

In our view, the market is looking beyond current conditions and focusing on the future, where prospects suggest stronger growth and potentially higher inflation down the road. While the consensus expectation has been for stronger growth in the second half of 2021, the election results appear to have pulled those expectations forward. With the presidency and majority in Congress held by one party, concerns about gridlock have given way to expectations of a faster recovery, more expansive fiscal policy, and higher inflation. The recent move up in yields may be a bit too much, too soon, but the overall direction in yields is likely to remain higher.

Here are three factors driving bond yields up:

1. The vaccine rollout has boosted optimism.

The pace of the economic recovery depends on the path of the COVID-19 virus and the ability to get it under control. After a slow start, it appears that the pace of vaccine distribution is picking up which has raised hopes for a stronger recovery, even amid a staggering rise in cases. Moreover, the incoming Biden administration has emphasized the need to get the pandemic under control as its top priority. Plans include employing federal resources to help fund a coordinated distribution effort. Anything that speeds up the vaccination process should help boost the economy by making it safer for people to congregate and resume activities that have been shelved.

The service sector2 is likely to benefit the most. Since the onset of the pandemic, jobs in the service sector and in local government have been the biggest contributors to rising unemployment.

Employment by industry, in thousands