Commuters exit a Wall Street subway station near the New York Stock Exchange on October 20, 2023.
Treasuries rallied, bouncing back from a slide that took the 10-year Treasury yield beyond 5 percent for the first time in 16 years, as investors start to question whether the economy can withstand current interest rates.
The 10-year yield rose as much as 11 basis points (bps), to 5.02 percent, the highest since 2007, before erasing its increase and falling as low as 4.83 percent. It was below 4 percent as recently as August 10, but has climbed since as investors have embraced the view that the Federal Reserve will keep its policy rate elevated indefinitely, until inflation returns to its 2 percent target.
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Also, bond investors are being asked to buy increasing quantities of Treasury notes and bonds. The U.S. budget deficit has grown, in part because of rising interest costs. At the same time, the Fed isn't replacing all of the Treasuries on its balance sheet as they mature. Dealers estimate that the outstanding debt will increase by $1.5 trillion to $2 trillion in 2024, versus about $1 trillion this year.
"Yields are rising because we are finally seeing supply come in," Tom Tzitzouris, head of fixed income research at Strategas Research Partners said on Bloomberg Television Monday. Fed rate increases and balance-sheet reduction are "catching up with the bond market now."
In August, the U.S. Treasury increased the size of its quarterly bond sales for the first time in two and a half years and said further increases would likely be needed in future quarters. Financing plans for the November-to-January period are set to be announced on November 1.
Yields haven't been this high since the era that preceded the Fed's experiment with unconventional policies—near-zero benchmark rates and quantitative easing—aimed at shoring up an economy that had been rocked by the sub-prime mortgage crisis and collapse of Lehman Brothers. Those policies were implemented on and off for 15 years—until the pandemic, and the wave of government spending it triggered, fueled an inflation surge that forced policymakers to raise rates closer to the norm seen for decades.
The Treasuries market is the world's biggest bond market, and Treasury yields are considered risk-free rates of return for the purposes of comparison with other investment opportunities. The rise in yields translates into higher borrowing costs for households, businesses, and governments in the United States and abroad.
The rise in yields has humbled the giants of the financial world, some of whom predicted that 2023 would prove to be the "year of the bond." The 10-year yield began this year at around 3.90 percent, and most Wall Street firms expected that it would decline as the Fed rate increases, which began in March 2022, took their toll on the economy and brought inflation to heel. Among major dealers, Goldman Sachs had the most bearish forecast, calling for a year-end level of 4.3 percent.
More recently, disdain for bonds has been powerful enough to offset haven flows into U.S. debt as the Israel-Hamas war has threatened to devolve into a broader Middle East crisis.
What Bloomberg's Strategists Say…
"After more than a year of being inverted, some of the key segments of the Treasury curve are about to revert to zero. That is usually taken as an imminent sign that the economy is about to contract or has entered a recession—but that isn't the case this time around. It has more to do with a higher neutral rate and rising real-risk premiums."
— Ven Ram, macro strategist
For some, 10-year yields at 5 percent appeared stretched in light of the threat they pose to economic conditions and the potential for haven demand to re-emerge.
Billionaire investor Bill Ackman said he covered a short bet on U.S. Treasuries, noting "there is too much risk in the world to remain short bonds at current long-term rates." Strategists at Wall Street banks including Goldman Sachs and Deutsche Bank said they expected the higher yields to draw buyers.
The selloff over the past two months has been led by long-dated bonds, which are more vulnerable to an extended period of elevated rates and robust growth. U.S. consumer prices advanced at a brisk pace for a second month in September, and economic data continues to point to a resilient economy.
"While levels look attractive in the near term, investors are likely to continue waiting for catalysts (such as geopolitical risks or slowing data) rather than catching the falling knife amid technical weakness," Gennadiy Goldberg and Molly McGown, strategists at TD Securities, wrote in a recent note. "This could keep rate volatility extremely high in the near term."
Another emerging threat to Treasuries is the changing composition of the market. Besides the Fed reducing its bond holdings, the holdings of foreign governments such as China's are waning. In their place, hedge funds, mutual funds, insurers, and pensions have stepped in.
The fact that they are less price-agnostic than their predecessors is leading to the revival of the the so-called term premium for bond pricing. That's where investors seek higher yields to compensate for the risk of holding longer-dated debt.
Longer-term, rates may be pushed above the levels of recent history. A new Bloomberg Economics report concludes that the combined impact of persistently high levels of government borrowing, more spending to fight climate change, and faster growth will mean a nominal 10-year bond yield in the region of 6 percent.
In the immediate future, the Treasury market remains on course for an unprecedented third year of annual losses.
Higher borrowing costs may ultimately serve as a brake on the U.S. economy, helping the Fed's inflation fight. The average rate on a 30-year fixed mortgage soared to around 8 percent in recent weeks, while the cost of servicing credit card bills, student loans, and other debts has also climbed as market rates have risen.
Powell echoed some of his colleagues by saying a sustained increase in yields could, "at the margin," lessen the pressure for tighter monetary policy. Bloomberg Economics reckons if the recent increase is sustained, it's the equivalent of about 50 bps of Fed tightening.
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