Amid horrific headlines about the Middle East and US Congressional chaos reaching new heights, investors and finance mandarins have kept a sharp eye on one dominant chart to gauge what may come next for markets: US 10-year Treasury yields, which have been grinding higher since late August.
Like any doctor taking a patient’s temperature or mechanic checking an engine’s oil, every assessment of the global economy begins with a check on the cost of borrowing money by the world’s richest and most powerful government. And while there are wide differences on what constitutes ‘normal’, we haven’t seen current levels since just before the Lehman Brothers collapse in 2008.
Rising yields have grave consequences, especially after four decades of falling rates. Higher borrowing costs can tip the US – and the world – into recession. They can trigger financial stress, especially where leverage is high and transparency is low. They drive up the value of the dollar, distorting trade flows that are settled in weaker currencies.
But it’s one thing to identify a feverish patient or an overheating engine. It’s quite another to determine the causes of the problem. It’s usually easier to start by excluding the obvious suspects and then see what’s left.
What’s not behind the rise
Knowing what we know today, a number of factors can be discounted as the cause of rising bond yields. The first is increasing inflationary pressures because inflation is easing. The path over the last year from a 9% consumer price index to the current 3.7% may be much easier than the effort still needed to reach the Federal Reserve’s long-term 2% target, but the worst inflationary pressures are clearly behind us.
Another is expectations of higher Fed Funds rates. Even with Fed Chair Jerome Powell’s tough talk about one more potential increase, markets believe this rate hike cycle is nearly over. Less confidence in the Fed’s determination is not a factor either. Surveys of consumer expectations or market measures of long-term inflation have not moved much at all.
Nor is the cause rising geopolitical tensions leading other countries to cut their Treasury exposure. China’s direct holdings seem to be in decline, but careful analysis reveals little change when ownership through other custodians and related accounts is included.
It’s also not because of the downgrade of the US by Fitch, which cited concerns around rising debt burdens and political polarisation that investors have priced in for decades. Similarly, it is not related to Congressional dysfunction, which has long been apparent even before the pandemonium that followed the dramatic ousting of Speaker of the House Kevin McCarthy.
The rising yields are not even indicative of the scale of borrowing yet ahead. The country’s debts have been rising steadily since 1980 as a percentage of gross domestic product under both Democrats and Republicans. The chance of default remains zero on debt issued in the world’s reserve currency.
What’s left to explain the shift?
Most likely it’s a simply question of supply and demand. There are more bonds for sale. The Treasury announced its predicted borrowing needs through next year that must cover larger deficits, weaker tax revenues and higher debt servicing costs.
There are also fewer buyers ‘at any price’ as several thoughtful observers have flagged. Not only does the Fed continue to unwind its balance sheet, but the world’s largest reserve banks are no longer actively accumulating dollar assets. This leaves mainly price-sensitive buyers who monitor inflation and prefer shorter-term debt unless 10-year bonds offer higher yields.
It’s little wonder that the term premium that measures additional compensation bondholders ask for against market risk has turned positive again. Nor is it any mystery why the ‘inverted’ Treasury curve – that haunting signal of imminent recession – should start steepening again. In principle, markets that pay more for longer loans mark a return to normalcy.
Of course, the risks remain that these higher rates will finally bite. Some hedge fund, emerging market or regional bank may yet find itself wrong-footed. Mortgage costs and credit burdens may finally ruin Christmas. But the macroeconomic data on corporate earnings, consumer spending and continuing wage gains all suggest that this holiday season still looks pretty good.
Meanwhile, yields should stabilise soon. If nothing else, Congressional paralysis will trigger a sequestration process that will limit next year’s deficit. Moreover, 10-year yields at current levels will start to look attractive as Fed rate cuts next year come into view.
None of this gets to the heart of America’s long term fiscal ills, which remain a problem to address through reforms of entitlement programmes. But it suggests relief may be in sight for what is – for now, mostly – a temporary market imbalance.
Christopher Smart is Managing Partner, Arbroath Group.
This is an edited version of the original article, published here.