Treasury bond yields have risen to their highest levels since late 2007, just before the 2008-09 financial crisis. They look to be climbing higher still—and well above the consensus estimates of investors.
There are two fundamental reasons. Inflation remains well above the 2% target set by the Federal Reserve, and despite its decline from four-decade peaks reached last year, it is unlikely to fall to an annual 2% rate in the next year, if at all. Moreover, real interest rates—nominal rates minus the rate of inflation—also are likely to be significantly 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%, and possibly 6%. That would be well above the 4.307% yield at Thursday’s close, which reflected a dramatic 1.022-percentage-point rise from the 2023 low touched in early April, in the aftermath of the failure of Silicon Valley Bank and several other banks.
Rather than sinking into recession, the U.S. economy has been mostly unaffected by the collapse of these few institutions. That has permitted the Fed to continue raising its key federal-funds target range, to 5.25%-5.50%.
As Greg Valliere, chief U.S. policy strategist at AGF Investments, wrote this past week, the big summer surprise has been a red-hot U.S. economy. Recession calls have faded with increased confidence about a “soft landing” or even no landing, especially after the latest Atlanta Fed GDPNow estimate showed real growth booming in the current quarter at a 5.8% annual rate.
Yet interest-rate markets continue to predict no further rate hikes from the Fed—and rate cuts starting as soon as May Day 2024, according to the CME FedWatch tool. Underlying that assumption is an expectation that inflation will move back down to 2%, from the 3.2% as measured by the consumer price index reading for the 12 months through July.
The decline in inflation, from a 9%-plus peak in mid-2022, was helped by a sharp drop in energy costs. The core CPI, which excludes food and energy costs, was up 4.7% in July from a year ago.
Wall Street economists always forecast that inflation will return to 2%, as Jim Bianco, the eponym of Bianco Research, pointed out in a webcast for clients this past week. The consensus of economists surveyed by Bloomberg looks for year-over-year CPI to recede to 2.4% by the end of 2025. Most economists haven’t accepted that inflation is likely to run at a higher rate, he added. Energy prices are on the ascent, with gasoline prices up 8.7% in the past month, according to AAA.
Fed Chairman Jerome Powell is unlikely to relent in his vow to get inflation back to 2% because higher prices hurt those who can least afford it, Bianco emphasized. He takes Powell at his word that the Fed won’t back away from that goal and will keep rates higher for longer.
That was underlined in the minutes of the most recent Federal Open Market Committee meeting of July 25-26, released this past week. “With inflation still well above the Committee’s longer-run goal and the labor market remaining tight, most participants continued to see significant upside risks to inflation, which could require further tightening of monetary policy,” read the passage that got the markets’ attention.
The economy is “not out of the woods yet with inflation,” J.P. Morgan’s global strategy team, led by Marko Kolanovic, wrote in a recent report. Despite a benign increase in the CPI in recent months (0.2% for core and overall retail inflation in July), the J.P. Morgan team sees core CPI proving to be sticky at a 3% annual rate.
If inflation remains dug in at 3%, Bianco thinks the 10-year Treasury yield could climb to 5%. He arrives at that figure by adding the 3% inflation rate and a 0.5% “neutral” real fed-funds rate, plus a 1.5% term premium, which is compensation for holding a longer-term security instead of a short-term instrument. But “it’s all about inflation” in estimating this higher bond yield, he says.
Former Treasury Secretary Lawrence Summers startled market observers this past week by declaring the rise in 10-year Treasury yields has further to go. The benchmark could average a 4.75% yield over the next decade, sharply higher than the 2.90% average of the past two decades, he said in a Bloomberg interview. Summers’ estimate was based on inflation averaging 2.5%, a neutral real rate of 1.5%-2%, and a term premium of 0.75%-1%.
Yet the surprise about Summers’ projection of a 4.75% 10-year yield was that there was any surprise, according to a note from Strategas’ technical and macro research team, led by Chris Verrone. This was around the average 10-year yield during the 1960s and the 2000s, albeit below the mid-6% range of the 1990s—ancient history to some, but not all of us.
The neutral real rate—dubbed R-star by economists—is the interest rate that, in theory, neither stimulates nor restrains the economy. It has been estimated to be about 0.5%, but a new study from the investment strategy group at Vanguard posits that R-star has risen by a full percentage point, to 1.5%. The rise in the neutral rate largely reflects the increase in the U.S. budget deficit, a factor also fingered by Summers.
Based on the higher neutral rate, the Vanguard researchers estimate that the fed-funds rate will remain above 5% until late 2024, even with higher projected unemployment. Over the long term, they see it averaging about 3.5%. By contrast, the FOMC’s most recent Summary of Economic Projections, set at its June 13-14 meeting, had a median projection for the fed-funds rate of 4.6% at the end of 2024 and a longer-run median of 2.5%.
Notwithstanding the expectations for lower rates evidenced in the fed-funds futures market and most economists’ forecasts, Bianco points out the Fed has never cut its policy rate in this century except when the economy was about to enter into a recession. That was case with the 2001 recession in the wake of the dot-com bubble’s bursting; the 2007-’09 recession that followed the housing-market crash; and the 2020 pandemic recession.
Even after 525 basis points of increases in the fed-funds target (a basis point is 1/100th of a percentage point), the level of official rates needed to slow the economy has yet to be reached, according to Joseph Carson, former chief economist at AllianceBernstein. The presumed lag effects of rate hikes are much less, or even nonexistent, when official rates are below inflation, as they were until recently, he writes in a blog post. Given the impact of the Fed’s past quantitative easing, an additional 100 basis points of hikes is needed, he adds.
Although the central bank’s balance sheet has been reduced since 2022, at $8.1 trillion it is nearly double its prepandemic level of $4.1 trillion in January 2020. The Fed’s still-huge securities holdings continue to provide liquidity and easy financial conditions despite its short-term rate hikes.
Looking ahead, the Vanguard team emphasizes that monetary policy makers need to consider the impact of structural budget deficits, which requires a higher neutral interest rate. The rise in R-star started before Covid hit and reflects secular forces, which also include aging demographics. Vanguard sees the former “new normal” of secular low rates having ended, perhaps giving way to a new era of “sound money.”
If so, that means higher bond yields than investors have grown accustomed to. And, if cheap-money policies persist, higher inflation would point to the same. Rising bond yields present a higher hurdle for stocks, at a time when the equity risk premium already is slim.
Powell is unlikely to declare “mission accomplished” on his inflation fight prematurely, Bianco concludes. That’s good news for consumers strapped by high prices, less so for investors unprepared for higher bond yields.
Write to Randall W. Forsyth at firstname.lastname@example.org