Treasury yields rose to their highest levels since late 2007, before the 2008-2009 financial crisis. They are looking to go higher steadily – and well above investor consensus estimates.
There are two main reasons. Inflation is stil
l well above the 2% target set by the Federal Reserve, and while it is down from four-decade highs last year, it is unlikely to drop to 2% per year next year, if at all. Moreover, real interest rates – nominal rates minus the rate of inflation – are also likely to be much higher than the near-zero levels that have prevailed since the financial crisis.
These factors could push the benchmark 10-year Treasury yield closer to 5%, possibly 6%. That would be well above a return of 4.307% at Thursday’s close, reflecting a dramatic 1,022 percentage point rise from the 2023 low touched in early April, in the wake of the failure of Silicon Valley Bank and several other banks.
Rather than slipping into recession, the American economy was mostly unaffected by the collapse of these few institutions. This allowed the Fed to continue to raise the key target range for the fed funds, to 5.25%-5.50%.
As Greg Vallier, chief US policy strategist at AGF Investments, wrote last week, the big surprise of the summer has been the inflamed US economy. Recession calls have died down as confidence about a “soft landing” or even a no landing has increased, especially after that The latest federal GDP estimates are out now in Atlanta Showing a real boom in growth in the current quarter at an annual rate of 5.8%.
However, interest rate markets are still predicting no more rate hikes by the Fed – and rate cuts will begin as early as May 2024, according to the Fed. CME FedWatch tool. This assumption is based on the expectation that inflation will ease to 2%, from 3.2% as measured by the CPI reading for the 12 months through July.
A sharp drop in energy costs has helped ease inflation, from a peak of a 9% surplus in mid-2022. The core CPI, which excludes food and energy costs, rose 4.7% in July compared to a year ago.
Wall Street economists always expect inflation to return to 2%, Jim Bianco, aka Bianco Research, pointed out in a webcast to clients last week. The consensus of economists surveyed by Bloomberg is for the CPI to ease year-on-year to 2.4% by the end of 2025. He added that most economists did not accept that inflation was likely to proceed at a higher rate. Energy prices are on the rise, with gasoline prices rising 8.7% in the last month, According to AAA.
Bianco emphasized that Fed Chairman Jerome Powell was unlikely to relent on his pledge to bring inflation back to 2% because higher prices hurt those who cannot afford it. Powell has taken his word that the Fed will not back down from this target and will keep rates higher for longer.
This was confirmed in the minutes of the last meeting of the Federal Open Market Committee on July 25-26, which were released last week. “With inflation still well above the Committee’s long-term target and the labor market remaining tight, most respondents continue to see significant upside risks to inflation, which could require further tightening of monetary policy,” reads the clip, which caught the markets’ attention.
JPMorgan’s global strategy team led by Marko Kolanovic wrote in a recent report that the economy is “not yet out of the woods with inflation.” Despite a benign increase in CPI in recent months (0.2% for core inflation and headline retail inflation in July), the JP Morgan team sees core CPI proving flat at an annualized rate of 3%.
If inflation remains at 3%, Bianco believes the 10-year Treasury yield could rise to 5%. He arrived at this number by adding an inflation rate of 3% and a “neutral” federal funds real rate of 0.5%, as well as a term premium of 1.5%, which is compensation for holding a long-term bond rather than a short-term instrument. But he says that “it’s all about inflation” in estimating the high bond yield.
Former Treasury Secretary Lawrence Summers stunned market watchers last week by declaring that the rise in 10-year Treasury yields should continue. He said the benchmark could average a return of 4.75% over the next decade, much higher than the 2.90% average in the past two decades. In an interview with Bloomberg. Summers’ estimate was based on an inflation rate of 2.5%, a neutral real rate of 1.5%-2%, and a term premium of 0.75%-1%.
However, there was no surprise about Summers’ prediction of a 4.75% 10-year return, according to a note from Strategas’ technical and macro research team, led by Chris Ferrone. This was about the 10-year average return during the 1960s and 2000s, albeit lower than the 6% average in the 1990s — ancient history for some, but not all.
The neutral real rate — called the R-star by economists — is an interest rate that, in theory, neither stimulates nor constrains the economy. The percentage was estimated to be around 0.5%, but a new study from Vanguard’s investment strategy group posits that the R-star rose by a full percentage point, to 1.5%. The rise in the neutral rate largely reflects the increase in the US budget deficit, a factor Summers also raised.
Based on the higher neutral rate, Vanguard researchers estimate that the federal funds rate will remain above 5% through late 2024, even with projected higher unemployment rates. Over the long term, they see an average of about 3.5%. By contrast, the FOMC’s most recent summary of economic outlooks, set at the June 13-14 meeting, had the median projection for the federal funds rate at 4.6% at the end of 2024 and the longer-term average of 2.5%.
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Despite expectations of lower rates evident in the federal funds futures market and most economists’ forecasts, Bianco points out that the Fed has never cut rates this century except when the economy was about to enter a recession. Such was the case with the 2001 recession in the aftermath of the bursting of the dotcom bubble. the 2007-2009 recession that followed the housing market crash; and the pandemic recession of 2020.
Even after 525 basis points of increases in the federal funds target (a basis point is 1/100th of a percentage point), the level of official rates needed to slow the economy has not yet been reached, according to Joseph Carson, former chief economist at AllianceBernstein. He wrote in a blog post that the supposed lag effects of higher interest rates are much less, or even non-existent, when official rates are below inflation, as they were until recently. He adds that due to the impact of the Fed’s previous quantitative easing, an additional 100 basis points of hikes are needed.
Although the central bank’s balance sheet has been reduced since 2022, at $8.1 trillion it is close to double the pre-pandemic level of $4.1 trillion in January 2020. The Fed’s massive securities holdings continue to provide liquidity and conditions Easy finances though with a short term interest rate. walking long distances.
Looking ahead, the Vanguard team stresses that monetary policymakers need to consider the impact of structural budget deficits, which would require a higher neutral interest rate. The R-star’s rise began before Covid hit and reflects secular forces, which also include older demographics. Vanguard argues that the former “new normal” of secular low rates is over, perhaps giving way to a new era of “healthy money”.
If so, that would mean higher bond yields than investors are used to. And if cheap money policies continue, rising inflation will indicate the same thing. Rising bond yields are an even bigger hurdle for equities, at a time when the equity risk premium is already slim.
Bianco concludes that Powell is unlikely to declare “mission accomplished” in his fight against inflation prematurely. This is good news for consumers suffering from rising prices, and less so for investors who are not ready to increase bond yields.
write to Randall W. Forsyth at randall.forsyth@barrons.com
(Tags to translation) Economic Performance / Indices
