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Returns on ten-year Treasuries are nearing 1.20% but economists at Capital Economics still would not expect Treasury yields to rise very sharply from here. They suspect that if they do increase over the next couple of years, it is likely to be driven by higher inflation compensation rather than higher real yields.

Key quotes

“We doubt that the nominal yield of 10-year conventional Treasuries will continue to rise significantly this year. Admittedly, we wouldn’t be surprised if inflation compensation increased further as the economic recovery gained traction. But we don’t think that this would lead to tighter monetary policy, and by extension, rising real yields.”

“We think the Fed would be comfortable with higher inflation compensation. By its own estimates, long-term inflation expectations are probably still below the level consistent with its policy goals. And in any case, the Fed has emphasised that it wants to see realised inflation sustainably above target before it considers any material tightening in monetary policy.”

“There may come a point over the next couple of years where higher inflation compensation prompts investors to reassess the outlook for monetary policy, thereby pushing up real yields. However, in this case, we suspect that the Fed may well take action to limit rises in yields, or even push them back down, to ensure that monetary conditions remain accommodative.”