Over the past few months intermediate- to long-term Treasury yields have moved higher by as much as 50 basis points,1 despite moderating inflation pressures. Several factors have contributed to the uptrend:
- The economy has been more resilient than expected, raising concerns about inflation rebounding.
- There is still a risk for more Federal Reserve rate hikes.
- Worries that the increasing supply of bonds that need to be issued due to rising fiscal deficits will mean that yields need to rise to find buyers.
While these concerns are likely to linger, we believe that they are largely discounted at current yields, and over the longer term we expect yields to fall. Short-term yields reflect market expectations that there may be one more rate hike of 25 basis points this year, while modest rate cuts are expected in the first half of 2024.
The rise in intermediate- to long-term yields reflects this potential for a “higher-for-longer” scenario. Intermediate- to long-term yields reflect expectations for the path of Fed policy plus a risk premium, or “term premium,” to compensate investors for tying up their money for longer periods of time. Consequently, with the Fed now expected to hold its benchmark federal funds rate2 at current levels or even raise it again, intermediate- to long-term yields have moved up. In fact, the rise in yields so far this year has been driven more by the increase in this term premium than by rising inflation expectations.
Markets expect cuts to the federal funds rate in 2024
Source: Bloomberg, Federal Reserve, as of 6/14/2023 and 8/31/2023.
The market estimate for the federal funds rate (blue line) uses the Fed Funds Futures futures implied rate (FFN3 COMB Comdty) as of 8/31/2023. The year-end 2023 median Fed projections (yellow line) represents the median value of the range forecast established by the Federal Open Market Committee (FOMC) as of 6/14/2023, the latest date on which projections were published. For each quarterly projections period, the median is the middle projection when the projections are arranged from lowest to highest; when the number of projections is even, the median is the average of the two middle projections. Futures and futures options trading involves substantial risk and is not suitable for all investors. Please read the Risk Disclosure for Futures and Options prior to trading futures products.
Tight Fed policy is cooling demand
We doubt the Fed will hike rates again in this cycle. After hiking the federal funds rate target to 5.5% from near zero in a little more than a year’s time, the impact of that policy tightening is showing up in economic data in the form of slower growth and lower inflation. Notably, the labor market, which is a key factor for the Fed in setting policy, is showing softness. Job openings have declined, hiring has slowed, wage growth is trending lower and the unemployment rate has ticked higher. The monthly pace of hiring has fallen to 150,000 on a rolling three-month basis, compared with more than 300,000 earlier this year. Wage growth is also slowing down, and the unemployment rate rose in August to 3.8%, the highest level since February 2022.
Job growth has slowed
Source: Bloomberg, using monthly data as of 8/31/2023.
US Employees on Nonfarm Payrolls MoM Change (NFP TCH Index).
Moreover, inflation is abating. The core Personal Consumption Expenditures (PCE) Price Index—the Fed’s benchmark inflation measure—rose by just 0.2% last month, for a year-over-year increase of 4.2% in August. Meanwhile, the overall PCE, which includes food and energy, rose only 3.3% year-over-year in August. On a three-month annualized basis, the changes in the headline and core PCE were just 2.1% and 2.9%, respectively—very near the Fed’s 2% inflation target.
Inflation has cooled
Source: Bloomberg, using monthly data as of 7/31/2023.
US Personal Consumption Expenditures Chain Type Price Index SA (PCE DEF Index) and US Personal Consumption Expenditure Core Price Index MoM SA (PCE CORE Index). Both the PCE Price Index and the PCE Price Index Excluding Food and Energy, also known as the core PCE price index, are released by the U.S. Department of Commerce’s Bureau of Economic Analysis as part of the monthly Personal Income and Outlays report. The core index makes it easier to see the underlying inflation trend by excluding two categories—food and energy—where prices tend to swing up and down more dramatically and more often than other prices. The core PCE price index is closely watched by the Federal Reserve as it conducts monetary policy.
In addition, the cost and availability of credit have risen steeply. Bank lending standards have tightened, making the costs for business and consumer loans soar. Consequently, loan demand is falling. Meanwhile, corporate profits have fallen for four consecutive quarters as the cost of capital climbs. A slowdown in business borrowing is usually a negative sign for investment and hiring. On the consumer side, rising mortgage rates have led to a slowdown in the housing market, while high credit card rates are subduing consumer demand.
Loan demand has declined
Source: Bloomberg, using monthly data as of 8/31/2023.
Federal Reserve’s Senior Loan Officer Survey: Net Percent of Domestic Respondents Demand for Commercial & Industrial Loans for Large/Medium Sized Firms and Small Firms (SLDEDEMD Index, SLDEDEMS Index). Shaded bars represent recessions.
Real interest rates are high
In addition, the increase in yields since the May low has come from higher “real” interest rates—that is, those adjusted for inflation. Inflation expectations have been steady, which should be reassuring to the Fed. Real interest rates are at the highest levels in more than a decade. At these levels, real rates are high enough to discourage business investment and spending.
Real interest rates are at the highest levels in years
Source: Bloomberg, daily data as of 9/5/2023.
US Generic Govt Treasury Inflation-Indexed (TII) 2 Yr (USGGT02Y INDEX), US Generic Govt TII 5 Yr (USGGT5Y Index), US Generic Govt TII 10 Yr (USGGT10Y Index). Indexes reflect inflation-adjusted yields. Past performance is no guarantee of future results.
Supply of Treasuries is rising
The rise in the supply of Treasuries that needs to be absorbed by the market is likely to loom large for a while. The federal government budget deficit has risen sharply this year and is projected to continue to rise, based on estimates provided by the Congressional Budget Office. At the same time, the Federal Reserve is stepping back from accumulating bonds on its balance sheet, removing a significant buyer of bonds from the market.
These concerns may limit how low yields can go as long as the economy is growing. However, in the long run, the correlation between deficits and interest rates is not a strong one. Inflation is a far greater driver of yields. Currently, the impact on inflation is likely to be limited because much of the rise in the deficit is due to higher interest costs, which don’t tend to feed into inflation because they don’t flow through to consumers or businesses.
On the demand side, concerns about foreign investors reducing their exposure to Treasuries appears overblown. Some countries, such as China, appear to be selling their Treasury holdings to support declining currencies. When a country’s currency falls sharply, its central bank raises money through sales of their holdings to buy their own currencies. China’s currency has fallen to nearly a seven-year low versus the dollar, which likely accounts for the selling. However, overall holdings of U.S. Treasuries by foreign investors remain near the record highs reached last year.
The amount of Treasuries held by foreign investors is near record highs
Source: Bloomberg, monthly data as of 6/30/2023.
With U.S. interest rates still higher than those in most other major countries and the dollar’s use in global transactions rising, foreign demand is likely to remain strong.
The U.S. dollar remains relatively strong
Bloomberg Dollar Spot Index (BBDXY Index). Daily data as of 9/5/2023. Past performance is no guarantee of future results.
We see the risk that yields could push higher in the near term. Over the long run the declining trend in inflation and softness in economic growth should allow yields to fall from current levels later this year and into 2024. It’s likely to be a bumpy ride, given the cross currents in the market. It’s very difficult to time the interest rate market. Waiting in short duration bonds until the Fed is done hiking rates increases reinvestment risk. Yields are at the highest levels in a decade and we don’t expect them to stay that high for long.
Moreover, we believe that the Fed is done hiking rates in this cycle. In the past four cycles, 10-year Treasury yields peaked before the last rate hike and then tended to trend lower. It’s unusual for long-term yields to peak after the last Fed rate hike. It hasn’t happened since the 1970s and early 1980s. While we can’t rule out a further rise in yields in the near term, we continue to see opportunities for investors to capture attractive nominal and real yields in their portfolios at current levels.
Treasury yields typically peak before the final rate hike of the cycle
Source: Schwab Center for Financial Research, Bloomberg, as of 9/6/2023.
US Generic Govt 10 Yr (USGG10YR Index) and Federal Funds Target Rate – Upper Bound (FDTR Index). Change in 10-year Treasury yield using monthly data, with the peak fed funds rate at month zero using the following months: February 1995, May 2000, June 2006, and December 2018. Past performance is no guarantee of future results.
Over the longer term, we look for yields to fall later this year and into 2024 as inflation continues to fall and suggest those higher yields present an opportunity to add duration to portfolios.