U.S. Treasury yields are on the move as inflation remains elevated, unemployment declines, and real GDP surpasses its pre-pandemic peak. Meanwhile, the Federal Reserve is withdrawing from its asset purchase program (aka quantitative easing or QE) and may end net asset purchases in the first half of 2022. After QE has been terminated, the Fed will consider raising its target range for the federal funds rate. All the while, COVID-19 complicates the picture with new variants.

But what exactly does all of this mean for how yields on U.S. Treasuries may move in 2022? What is key to understanding how the shape of the yield curve may change in the year ahead?

Was the more than 6% elevated inflation rate observed in 2021 supply or demand driven? Both. Every product or service that changes hands has a seller (supply) and a buyer (demand), so the analysis of why prices move always involves both supply and demand. In the case of the pandemic, supply and demand were impacted in very unusual and atypical ways.

The two major changes on the demand side were 1) the direct payments to individuals by the U.S. federal government to cushion the blow from the partial shutdown of the service sector, and 2) the shift in consumption patterns away from services and toward goods.

First, the direct payments to individuals allowed a much more rapid recovery of personal consumption back to pre-pandemic levels than otherwise would have been possible, and by the end of 2021, real GDP was about 3.5% above the pre-pandemic peak of Q4 2019. The 3.5% growth over two years was an amazingly rapid recovery from the pandemic shock, yet was well below average demand growth for a two-year period. So, we do not give much general demand-side credit to fiscal policy in terms of influencing the elevated rate of inflation observed in 2021 even if it helped create a more rapid recovery from the shock.

Second, the relative shift away from spending on services to goods was a major upward demand shock for goods that exacerbated supply chain challenges and impacted goods inflation in 2021. That is, the demand influence that was important for inflation came from a relative shift in demand from services to goods and not an overall, persistent increase in general demand.

On the supply side, there were myriad challenges. In some cases, ports were impacted by COVID-19, which disrupted the loading and unloading of containers. Container production slowed in the spring of 2020 and then took time to ramp back up to meet the rising export of goods coming from China to the U.S. and Europe, due to the relative shift to consumption of manufactured goods. The shift to goods also resulted in computer chips being in short supply, leading to a slowing of automobile production and pushing the prices of used cars to all-time highs. These were just a few of the many supply chain disruptions induced by the pandemic.

Taken together, supply chain disruptions due to COVID-19 and the relative shift to goods consumption get most of the credit for the elevated rate of inflation that developed in 2021. This analysis has important policy implications because typical demand-side policy responses, such as raising interest rates, cannot cure supply disruptions, especially those due to COVID variants that might disrupt international transportation and other aspects of the supply chain. Still, in late 2021, with real GDP fully recovered, labor markets robust, and inflation elevated, the demand-supply combination worked to impact expectations that the Fed might eventually return to a neutral monetary policy: that is, no asset purchases and short-term rates more or less aligned to the Fed’s 2% inflation target, sooner rather than later.

How might the U.S. Treasury yield curve respond to higher short-term rates? Not clear. There are no less than three plausible scenarios being debated: 1) flattening, 2) steepening, and 3) a parallel shift upward. Let’s examine each scenario from the perspective of the yields on U.S. Treasury 2-year and 10-year notes.

First, as always, context matters. In late 2021, consumer price inflation above 6% was elevated well over the Fed’s 2% target. Real GDP had fully recovered from the pandemic shock, and labor markets were robust with falling unemployment, record job openings, and elevated voluntary job quits. In response, the Fed decided to start the process of ending its asset purchase program, and market participants began to debate when the Fed would commence raising short-term interests as well as how high they might eventually go.

In scenario no. 1, a flattening of the Treasury yield curve would mean that yields on the 2-year would rise relative to yields on the 10-year. In scenario no. 2, a steepening of the Treasury yield curve would mean that yields on the 10-year would increase relative to yields on the 2-year. Scenario no. 3 is where the yields on both the 2-year and the 10-year go up (or down) in tandem; that is a parallel shift in the whole curve.

•  The flattening scenario might occur if inflation in 2022 started to decline quickly back toward the Fed’s 2% target or if equity markets swooned and there was a flight-to-quality to longer-term U.S. Treasuries.

•  By contrast, the steepening scenario might occur if inflation, especially core inflation (excluding food and energy) remained elevated above 3% and did not seem to be decelerating back to the Fed’s 2% target.

•  The parallel upward shift scenario suggests the Fed raises short-term rates in regular steps, perhaps every other FOMC meeting while inflation stays elevated. Critically, the Fed is perceived as acting “too little, too late,” making the end-point for rate hikes highly uncertain.

It is a fascinating market debate, and only time will tell which scenario ultimately becomes reality. Indeed, at various times, all three scenarios might have their day in the sun.

In the past, what has been the driver of the inflation risk premium embedded in U.S. Treasury 10-year yields? The relationship of the U.S. Treasury 10-year yield to the observed inflation rate is all about context and expectations.

In the inflationary 1970s, there was both an accommodative monetary policy and OPEC oil price shocks, which led actual inflation to surprise market expectations to the upside. This meant that the inflation premium embedded in 10-year yields was eroded, as rises in Treasury yields lagged the unexpected increases in the inflation rate. In the 1980-82 period, super-high short-term interest rates caused a recession and broke the back of inflation. For the next 30 years, observed inflation decelerated, yet it took time (i.e. decades) for inflation fears to subside and the inflation premium to shrink. During this 1980s, 1990s, and early 2000s period, inflation consistently surprised on the downside, and it took decades for yields to catch up to the new reality of sustained low inflation.

The advent of Fed quantitative easing and an era of low short-term rates following the Great Recession of 2008-09 changed the context. There is a saying in the markets – “don’t fight the Fed” – and with Fed buying Treasuries, the European Central Bank (ECB) pushing yields into negative territory, and low short-term rates in all the major countries, the inflation premium completely disappeared.