Rising yields and a steeper yield curve are par for the course as an economy enters the recovery phase of the global credit cycle. While rising yields are often painful for bond investors as bond prices decline, we view them as a signal that global reflation efforts are taking hold. Yields typically adjust as investors rebalance their portfolios and shift toward more risky assets that may offer higher expected returns.

However, we believe the recent spike in real yields suggests there’s been a handoff in the reflation trade. The pace of the increase in nominal yields accelerated from an average rise of 20 basis points every two months to about 50 basis points just in the last month. As the pace accelerated, the primary driver of the increase in yield shifted from increasing inflation expectations to rising real yields. We believe this shift has caused a dent in risk appetite. The rise has fanned out into other markets, with global bond yields rising and some risk markets coming under pressure. Many people are recalling the 2013 “taper tantrum” when real yields spiked 150 basis points over three months because it coincided with a sharp hit to risky assets. They’re wondering if this could become a repeat. We don’t think so, but the outlook deserves some caution. Here, we’ll look at what happened and what may come next.

What happened?

Yields have been rising since August 2020. Up until last month, the cumulative rise in nominal yields had primarily been driven by rising inflation expectations. We viewed that as a positive development and part of the economic reflation process. It indicated that markets were bringing inflation expectations back toward historical levels in the 2.0% to 2.5% range. During this period, the cumulative rise in real yields hovered around zero and that coincided with a solid rebound in risk appetite.

Then, in the middle of February, President Biden’s full $1.9 trillion fiscal stimulus plan gained momentum in Congress and markets began to reassess the growth outlook. With tremendous fiscal support, pent-up demand and supply shortages, some street estimates began calling for GDP growth to reach more than 6% in 2021 and more than 4% in 2022. The market started questioning if real yields could stay low in such a strong, sustained growth scenario. Would the Fed let the economy run at these levels without raising interest rates? Would it have to hike more frequently than expected to keep a lid on inflation? Would the terminal federal funds rate be much higher than the 2.5% level guided to by the Fed? These questions triggered a slightly more sinister change in the pace and composition of rising yields.