After rapid rate increase to start 2022, investors see benchmark 10-year yield rising to 2% soon

The bond market is signaling that interest rates are about to rise on Main Street.

Treasury yields are pushing higher at the fastest new year pace in 20 years. The closely-watched benchmark 10-year Treasury yield was as high as 1.71% Tuesday, after ending 2021 at 1.51% Friday afternoon.

The 10-year yield is important since it influences lending rates for mortgages and many other business and consumer loans. When bonds sell off, yields, or interest rates, go higher.

“The year has really started off with a bang here,” said Robert Tipp, head of global bonds and foreign exchange for PGIM Fixed Income. “The market’s been getting kind of bounced back and forth between the downside risks to the economy from Covid …and then ping ponging back to the other side, which is the economy continues to do pretty well. Inflation is high and the Fed is on track to raise rates.”

The Federal Reserve cleared the way for higher interest rates in December when it forecast three quarter point interest rate hikes for next year and said it would now end its bond buying program by March, instead of June. The Fed joins other central banks around the world in tightening policy, including the Bank of England which has already raised interest rates.

“I think the economic optimism with a backdrop of inflationary concerns will get 10-year yields to 2% sometime in the first quarter,” said Ian Lyngen, head of U.S. rates strategy at BMO. The economy and the Federal Reserve will determine how high it goes from there.”

But after that spurt to 2%, strategists are not expecting the yield to go sharply higher this year.

“It’s going to be a function of the data and it’s going to be a function of the tone from the Fed. That said, we’re not going to 3%,” said Lyngen. “I think we’ll peak early in the year.”

The Fed’s mid-December meeting was just days after the report of November’s consumer price index, which showed inflation rising at a pace of 6.8%, the fastest since 1982.

But instead of jumping higher on the Fed news, bond yields continued to trade lower as investors bought Treasurys as a safe haven should the omicron Covid variant slow the economy. But those concerns have ebbed as studies show that the rapidly spreading strain is not as severe in terms of hospitalizations and deaths.

The one-day jump in the 10-year yield on Monday was the biggest move for the yield on the first day of trading since 2001, according to Michael Schumacher, director rates strategy at Wells Fargo. In 2001, the yield moved 24 basis points, or 0.24%. On Monday, the yield rose from Friday’s 1.51% to just over 1.64%, according to TradeWeb.

Schumacher said the move could come early in the year, and in the first weeks of January there could be a few catalysts. The Fed releases minutes of its last meeting Wednesday afternoon, and the December employment report is released Friday. Next week, December’s CPI is reported and it could again show a very hot pace of consumer inflation.

But while Schumacher does not expect the 10-year to go much higher than 2.25% this year, the inflation picture could determine where it goes. “There’s always a chance inflation is tough to stamp out and the Fed and other central banks have to get more aggressive,” he said.

In the scheme of things, rates are still very low. The 30-year mortgage rate is currently at 3.22%, up from 3.16% on Dec. 24, according to Bankrate.

Yields have moved higher across the curve. The 2-year yield, which is most directly impacted by Fed policy, is up slightly from Friday’s level. It actually moved lower to 0.75% Tuesday from a high 0.80% Monday.

Tipp said rates at the longer end, like the 10-year, historically were driven by longer term expectations about the economy. But since the financial crisis in 2008, the 10-year has mostly yielded less than 3%. It last closed above 2% on July 31, 2019.

“The long rates are becoming more heavily impacted as well, not so much by what people guess is the outlook for long term growth and inflation but almost equally important what people think is going to be central bank policy,” said Tipp. Tipp said while the expectations on Wall Street are for a 10-year yield at just above 2% at year end, he expects it to be at 1.50% or lower because he foresees a slower economy and still hot inflation.

Tipp said he does not expect the rise in rates to have as much an impact on the economy as it has in the past. “The movement in rates are so muted these days. The impact of rates on the economy has become a lot more muted. Housing for individuals is the key market that’s impacted by long term rates,” he said.

Inflation could be the ultimate driver of where the 10-year yield goes this year.

“The final tone at the end of the year will be a function of whether or not inflation moderates sufficiently and importantly what happens to growth expectations for next year,” said Lyngen.