On Asset Allocation
A Surprising Rise in U.S. Treasury Yields
Christina Noonan, CFA, Associate Portfolio Manager, Multi‑Asset Division

The sharp rise in U.S. Treasury yields has defied many investors’ expectations that weaker growth and moderating inflation in the back half of 2023 would lead to lower rates. Despite evidence that inflation is coming down and the Federal Reserve [Fed] is approaching peak policy rates, 10-year Treasury yields have surged to levels not seen since late 2007, catching many defensively positioned investors by surprise. There are several factors that have pushed yields to their recent highs.

At the core of the spike higher in yields has been the unexpected resilience of the economy. Data has continued to surprise to the upside, particularly the unrelenting strength of the labor market, solid consumer spending, and above-trend growth. According to the Atlanta Fed GDP Now estimates, GDP is expected to show an acceleration next quarter of 5.8% from 2.4% in the second quarter, further pushing out expectations of a slowdown or recession. Strong economic growth has also reignited concerns that inflation may not continue to decelerate at the same pace that we’ve seen.

Despite the Fed having already raised the fed funds rate to 5.5%, the lagged negative effects on the economy, particularly in the labor and housing markets, have taken longer than many expected. The tightness of the labor and housing markets have also led to stickier-than-expected inflation and will likely keep the Fed hawkish longer, despite market expectations for cuts early next year. However, the market has just recently started to come around to this shift to a higher-for-longer Fed narrative, as reflected through the fed funds futures market.

On the technical front, there are also supply and demand dynamics that have further exacerbated the recent climb in yields. On the supply side, at the end of July, the U.S. Treasury surprised the market when it announced it would need to issue more debt than expected to fund the U.S.’s growing budget deficit. This timing also coincided closely with Fitch downgrading the U.S. government’s credit rating, where they cited concerns around the size of deficit spending and need for additional issuance as catalysts for the downgrade.

These concerns surrounding future U.S. Treasury supply have also come at a time when demand is falling as the largest Treasury owners, the Federal Reserve and foreign buyers, are buying less U.S. debt. The Fed is expected to continue rolling off its balance sheet as part of quantitative tightening, placing upward pressure on Treasury yields. At the same time, as bond yields outside the U.S. start to look more attractive relative to Treasuries, foreign buyers’ demand for Treasuries could continue to fade.

With the resilience of the U.S. economy and potential for the Fed to remain engaged longer than many expected—if if they stick to their 2% inflation target—there is a possibility that rates may still have more room to run and that the neutral rate is far higher than many investors initially believed. However, this readjustment in yields has also led to longer-duration yields becoming increasingly more attractive and could present potential opportunities to add.

There are several reasons that we could see a continuation of higher rate volatility, and while it is hard to predict if we have seen the top in rates, we surely are unlikely to revisit the zero level of rates that we started this cycle with anytime soon. With this as a backdrop, the Asset Allocation Committee has remained balanced across fixed income, maintaining an overweight to cash and cash equivalents, while opportunistically adding to longer-term Treasuries amid the recent move up in rates.

Key Insights
  • A sharp rise in U.S. Treasury yields—pressured by a resilient U.S. economy and supply and demand imbalances—has caught many investors by surprise.
  • We believe that interest rate volatility is likely to persist as the U.S. Federal Reserve pursues a 2% inflation target and restricts monetary policy for longer than expected.

Despite evidence of easing inflation and peaking policy rates in the U.S., 10-year U.S. Treasury yields surged in July and early August to levels not seen since late 2007, catching many defensively positioned investors by surprise. Several factors have pushed yields higher, including the strong U.S. economy and supply and demand imbalances in the U.S. Treasury market.

U.S. economic data have continued to surprise on the upside, led by labor market strength, solid consumer spending, and above-trend growth. This has pushed out expectations of a sharp slowdown in growth or a recession. Meanwhile, the economic impacts of the Fed’s aggressive rate hikes have been delayed, and inflation has proven stickier than expected, especially in labor and housing markets. As a result, investors now expect rates to remain higher for longer, a shift reflected in the federal funds futures market (Figure 1).

The Federal Reserve Is Expected to Remain Hawkish for Longer

(Fig. 1) Fed funds futures curve

Line charts showing the fed funds futures yield (plotted on the left axis). A difference in the two lines shows that market expectations have shifted higher over the one-month period from July 14, 2023, to August 16, 2023. The change in basis points (right axis) is plotted in bars and shows the climbing expectations for higher rates for longer.

July 2023 through August 2025. The one-month change is between the data as of July 14, 2023, and August 16, 2023.
Actual outcomes may differ materially from estimates. A basis point (bps) is 0.01 percentage point.
Source: Bloomberg Finance L.P.

Demand for U.S. Treasuries Is Fading

(Fig. 2) Ownership shares of outstanding U.S. Treasuries

A shaded chart plotting the two largest owners of U.S. Treasuries—the Federal Reserve and foreign investors—from March 1989 to March 2023, showing the falling demand for Treasuries.

March 31, 1989, through March 31, 2023.
Source: U.S. Treasury/Haver Analytics.

Supply and demand dynamics in the U.S. Treasury market have also pressured yields higher. On the supply side, the U.S. Treasury surprised markets at the end of July when it announced the need to issue more debt in order to fund the government’s growing budget deficit. This additional supply comes at a time when demand has been falling (Figure 2). The largest Treasury owners—the Federal Reserve and foreign investors—have been buying less U.S. debt amid quantitative tightening and more attractive yields on global bonds relative to Treasuries.  

Rate volatility is likely to persist, in our view. As the Fed pursues a 2% inflation target, U.S. monetary policy also may remain restrictive for longer than many previously expected. While it is hard to predict if we have seen the top in rates, we believe a much higher neutral rate1 is likely given the resilient U.S. economy.

With this backdrop, our Asset Allocation Committee has remained balanced across fixed income sectors, maintaining an overweight to cash and cash equivalents while opportunistically adding to longer-term Treasuries amid the recent move up in rates.

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1 The neutral rate is considered to be the interest rate at which monetary policy is neither stimulating nor restricting economic growth.

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Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of September 2023 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

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