U.S. Treasury Yields, Up, Up, and Away…?

Transcript

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 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.