Investors’ acknowledgment that we are in a “higher-for-longer” interest rate environment could bring about a “lower-for-longer” growth paradigm. Paradoxically, this would come at a time when many commentators are dropping their recession calls.
Over the last three weeks, the yield on 10-year Treasuries has surged over 50 basis points (bps) to 4.8% — the highest level since 2007. And with yields up over 100bps since mid-July, many investors are now contemplating the possibility of the benchmark yield surpassing 5%. In fact, yields briefly touched 4.88% after the very strong September jobs report.
The entire interest rate curve has moved upward over the last couple of months, but yields on long-term Treasuries have risen faster than yields on short-term rates, leading to a gradual dis-inversion of the yield curve. The rise in the cost of debt will further restrain homebuyers, consumers and business executives in their purchase and investment decisions, leading to slower economic activity in the months to come.
While no one knows for sure what the underlying drivers of the recent bond market selloff are, it’s important to understand the likely catalysts to gauge potential economic and financial market ramifications.
Looking at Treasury Inflation-Protected Securities (TIPS) rates, inflation expectations are not driving the rise in yields. In fact, 5-year inflation expectations have been very stable around 2.2% over the past couple of months as realized inflation has continued to moderate.
The rise in real interest rates, meanwhile, doesn’t seem to be reflecting stronger growth expectations with economic momentum in the US and other regions around the world slowing. In fact, the dis-inversion of the yield curve indicates that investors are not looking for central banks to tighten monetary policy further.
So, what is driving recent market developments?
First, market participants appear to have come to grips with the fact that the Fed and other central banks are serious about maintaining their current restrictive monetary policy stance well into 2024, and that they are unlikely to proceed with early rate cuts. Paradoxically, the recent tightening in financial conditions also means that markets are doing some of the Fed’s tightening work. This implies that policymakers are less likely to proceed with an additional rate hike this year, confirming our view that the Fed’s tightening cycle is now complete.
Second, the rise in long-term bond yields likely reflects an expected rise in r-star – the inflation-adjusted natural rate of interest that is neither expansionary nor contractionary from a monetary policy perspective. Whereas the natural rate was estimated to be around 0% on a real basis and around 2% on a nominal basis before the pandemic, there may be reason to believe that it is now higher. This would lead to long-term interest rates factoring a higher trajectory for the short-term policy rate over the coming years.
A third important driver of the rise in long-term yields appears to come from the supply side. The federal government deficit is expected to reach nearly $2t in fiscal year 2023 – the largest deficit outside of a recession. With the Congressional Budget Office projecting federal government deficits around $1.5t to $2t over the next decade and debt-servicing costs rapidly rising, investors are demanding a higher yield on Treasuries.
Fourth, it may also be reflecting less predictable demand from the Fed, other central banks, and public and private sector investors. The Fed has been normalizing the size of its balance sheet by allowing $60b of Treasury securities and $35b of mortgage-backed securities to mature each month. With its asset holding falling $1t since mid-2022, the Fed is no longer the marginal buyer of Treasuries it once was while commercial banks, hedge funds, pension funds and insurance companies have shown a reduced appetite for Treasury securities.
This leaves us with the very real possibility that rates could still drift higher, or at least stabilize at these higher levels in the coming weeks. Indeed, the main anchor for rates going forward is likely to come from the Fed’s reaction to the tightening of financial conditions and a likely easing in economic activity. Forward guidance indicating a less hawkish stance or tweaks to its balance sheet normalization process could be key in guiding long-term rates.
In the meantime, the rapid tightening of financial conditions will continue to increase the odds that something “breaks" in the economy. We see recession odds over the next 12 months having increased from 40% to around 50%-55% because of recent market developments against a backdrop of more subdued final demand.
