In recent months, the dynamics of U.STreasury rates have exhibited remarkable volatility, reminiscent of a horse galloping untetheredOver a span of two months, yields surged from approximately 2.6% to a staggering 4.3%, marking the highest levels since 2008. This significant uptick raises concerns regarding whether these rates have fundamentally deviated from their equilibrium values and what implications this may have in the broader economic landscape.
The principal drivers of the rising Treasury yields have been persistent inflationary pressures coupled with the Federal Reserve's aggressive monetary tightening measuresHowever, the rapid increase in bond rates cannot be solely attributed to the actions of the FedEconomic factors have started to exhibit signs of dislocation, hinting at a departure from fundamental valuesFor instance, Treasury Secretary Janet Yellen has voiced concerns regarding the current lack of liquidity in the U.S. government bond market, compounded by various central banks selling off U.STreasuries to support their own currencies.
The yield on 10-year U.STreasuries serves as a benchmark for pricing risk assets globallyAs this benchmark spikes, it is expected to induce ripple effects across different asset classes, amplifying volatility in global financial marketsThe widening interest rate differential between U.STreasuries and bonds in other economies has substantially strengthened the U.S. dollar, creating immense depreciation pressure on non-dollar currenciesTo illustrate, the Japanese yen has plummeted to around 150 per dollar, the lowest level seen in over thirty years, while the euro and pound have descended towards parity, with the pound reaching its weakest position since 1985.
The perception of U.STreasury yields as a proxy for risk-free returns in asset pricing means that any abrupt rise can devalue myriad investments, particularly in equities
Advertisements
Since 2022, global stock markets have faced substantial downturns, with the Nasdaq composite index dropping nearly 30%, the S&P 500 declining about 20%, and the Hang Seng Index witnessing a more than 35% plungeIn Germany, the DAX index fell by roughly 18%. This environment emphasizes the interconnectedness of credit markets and stock valuations.
Interestingly, the pricing of financial assets is not always grounded in rationalityThe steep rise in U.STreasury rates seems to diverge significantly from the equilibrium prices dictated by the Fed's rate hikes, inflation, and the broader economic indicatorsShould circumstances shift, this dislocation could reverse course rapidly, leading to a swift recalibration of market expectations.
Since the 1980s, U.STreasury yields have been in a long-term downtrend, spanning almost four decadesThe question arises as to whether the recent uptick signifies a mere cyclical change or a historical turning point, marking a potential end to the long-standing downward trajectory of yields.
The Federal Reserve remains at the center of this financial whirlwind, having implemented the most aggressive rate hikes seen in recent historyIn 2022, the Fed increased rates cumulatively by 300 basis points by October, making consecutive hikes of 75 basis points during meetings in June, July, and SeptemberBy shifting the benchmark interest rate, the Fed influences overall market rates, consequently resulting in a steep rise in Treasury yieldsDuring this tightening cycle since mid-2021, the rate for 10-year U.STreasuries surged from around 1.5% to approximately 4.3%, while the more sensitive 2-year note ascended from 0.2% to nearly 4.6%. Additionally, mortgage rates in the U.S. have leapt from approximately 2.8% to nearly 7%.
Since August, the rapid ascent of Treasury yields has closely correlated with heightened expectations surrounding Fed interest rate adjustments
Advertisements
Analyzing the dot plot projections from the Fed’s meetings in June versus September reveals this shift clearlyIn June, officials anticipated a terminal rate target of around 3.5%-3.75%, but by September, expectations had been markedly raised to 4.5%-5%.
However, the recent surge in 10-year Treasury rates considerably outstrips the changes in rate hike expectations, suggesting extraneous factors are influencing the U.S. bond marketDespite the vast scale and liquidity of this market, growing concerns over diminishing liquidity due to major buyers exiting has recently come to the forefront.
The largest sovereign holders of U.S. debt, including China and Japan, have notably curtailed their purchases, contributing to fears surrounding liquidity strains within the Treasury marketReports from China International Capital Corporation indicate that liquidity in the Treasury market resembles levels seen in March 2020 during the early stages of the COVID-19 pandemic, marked by significant disruptions.
Moreover, the depreciation of many non-U.S. currencies has led those nations to intervene in currency markets, which effectively necessitates the sale of U.S. bonds to procure more dollarsThis action further exacerbates the selling pressure on Treasuries and increases market volatility.
For example, both Japan and South Korea have undertaken direct interventions in their currency markets, resulting in steep declines in their foreign exchange reservesAs of the end of September, Japan’s reserves stood at approximately $1.238 trillion, a reduction of over $54 billion from the end of August and the largest monthly decrease on recordMeanwhile, South Korea reported a drop in reserves to around $416.8 billion, a decrease of $19.7 billion—marking the most significant monthly fall since the 2008 global financial crisis.
Will Treasury rates continue to rise? The short-term trajectory is likely contingent on whether the pace of Fed rate hikes begins to moderate
Advertisements
Predictions suggest that the Fed may raise rates by another 125 to 150 basis points in November and DecemberYet, there is a consensus emerging that the Fed is entering the latter stages of this tightening cycle, inching closer to the terminal point.
CICC likens the current U.S. debt situation to the state of oil markets in April 2020. The pricing dynamics have pushed to extremes, projecting a high likelihood for a reversal in future conditionsAssuming the Fed's terminal rate aligns around 4.8%, the equilibrium price for the 10-year Treasury yield would be approximately 3.2%, indicating the current market pricing is excessively above equilibrium values by around 100 basis pointsObserving the U.S. economy veering towards recession appears inevitable, suggesting inflation may improve and Treasury rates are likely to fallIt becomes increasingly crucial not to follow market trends blindly while neglecting underlying fundamental analysis.
In the long term, the Federal Reserve's cycles of tightening and easing emerge fundamentally from economic realities, with the interplay between growth and inflation dictating the course of Treasury yieldsInterest rates bridge the supply and demand for capital, while fundamental factors such as investment and consumption dictate economic growth levelsThus, over a longer horizon, the central tendency of interest rates is influenced by the trajectory of economic growth: as growth improves, interest rates tend to rise correspondingly; conversely, if growth declines, the capacity to withstand higher rates diminishes.
Despite being a reflection of nominal capital costs, if inflation continues to surge, nominal interest rates are bound to rise as well, ensuring that borrowing costs adequately compensate for the erosive effects of inflation.
Post-World War II, U.S
Advertisements
Advertisements