Really, A Soft Landing?

The threat of a bond selloff looms large, casting doubt on hopes for a soft economic landing. The surge in long-term interest rates, reaching levels not seen in 16 years, raises concerns, especially as the exact triggers behind this move remain unclear.

  • On Tuesday, yields on the 10-year Treasury note spiked by 0.119 percentage points to 4.801%, marking the highest point since the start of the subprime mortgage crisis in August 2007. This surge prompted a 1.3% drop in the Dow Industrials, erasing all gains for the year, and declines in the S&P 500 (1.4%) and the Nasdaq Composite (1.9%).
  • For the past 18 months, the Federal Reserve has steadily increased short-term rates, a move intended to drive up long-term bond yields to curb inflation and slow down the economy.
  • However, the rapid rise in rates at this juncture could have unintended consequences. It comes as inflation shows signs of easing, and the Fed hints at concluding its rate hikes.

The Yield Curve Is Un-Inverting

If this recent upward trend in borrowing costs continues, along with a concurrent decline in stock prices and a stronger dollar, it could significantly slow both the U.S. and global economies over the next year. Additionally, the rapid pace of this rise heightens the risk of financial market disruptions. The most likely culprits behind this phenomenon seem to be expectations of improved U.S. economic growth and concerns that massive federal deficits are straining investors' capacity to absorb such a high level of debt.

  • Unlike last year when rising long-term Treasury yields were driven by market expectations of higher short-term rates due to Fed policy tightening and investors' demand for extra compensation to hold longer-dated assets amid fears of inflation, these factors are not currently driving rates higher.
  • This shift in focus has raised questions about other influences, including reduced foreign demand for Treasuries, decreased interest from U.S. banks, and domestic portfolio managers who traditionally invested in government bonds as a safeguard against stock market downturns and other risky assets.

No Clear Driver

Treasury Secretary Janet Yellen acknowledged the uncertainty surrounding the future levels of bond yields, highlighting the administration's concern. The lack of a clear catalyst for the recent increase in longer-term yields suggests that the term premium, the additional yield investors demand for holding longer-dated assets, is on the rise. This marks a significant departure from the low-inflation, low-growth environment observed between the 2008-09 financial crisis and the COVID-19 pandemic.

  • A higher term premium means borrowers will face higher costs even if inflation remains under control because investors require greater compensation for locking up their money for extended periods.
  • A sustained increase in Treasury yields could prove costly for the U.S. government, leading to higher borrowing costs for its substantial debt load, which has doubled to around $26 trillion over the past eight years.
  • The spike in borrowing costs is also pushing mortgage rates to 23-year highs, with some lenders quoting rates above 7.5% for 30-year fixed loans. Elevated borrowing costs could weigh on asset prices, leading to reduced investment, hiring, and economic activity.

Daleep Singh, Chief Global Economist at PGIM Fixed Income, expressed his perplexity, stating that no fundamental explanation is convincing.

Higher Rates For Longer

Investors still believe the Fed is nearing the end of its rate hikes but now see a higher likelihood that the central bank will maintain rates at current levels through the next year. The expectation of fewer rate cuts compared to three months ago has also become more prevalent. The recent surge in bond yields gained momentum in late July as the economy showed signs of reacceleration, fuelled by stronger-than-expected consumer spending. This shift led investors and Fed officials to revise their predictions, abandoning the expectation of an economic stumble.

  • Fed officials have upgraded their outlook for economic growth next year, attributing it to robust underlying momentum. This has also been reflected in market participants' expectations.
  • Fed Chair Jerome Powell conceded in September that rate hikes hadn't slowed the economy as much as expected. Some officials suggest that the government's response to the pandemic made the private sector more resilient to higher interest rates, while others speculate that interest rates simply haven't been elevated long enough to significantly impact demand.

The current situation contrasts with the previous decade when the economy seemed less responsive to monetary stimulus, leading officials to consider a lower neutral rate. Now, some are exploring the possibility of a higher neutral rate.

Strong Consumption Despite Higher Rates

Investors are grappling with the puzzle of strong consumption despite the Fed's aggressive rate hikes. If the reason is a higher neutral rate, the Fed may keep rates elevated for a longer duration, justifying the recent bond yield increase. If it's due to the traditional lag in the effects of monetary policy, the economy could slow down in due time.

  • Investors are also contemplating the prospect of greater inflation volatility in the global economy in the years ahead. This could occur if the factors that contributed to low inflation and interest rates after the 2008-09 financial crisis, such as globalization, favorable demographics, and abundant cheap energy, weaken or reverse.
  • As the supply of government securities increases, coupled with some buyers stepping back from the market, a more positive growth outlook could lead to reduced demand for Treasuries. The Fed's previous bond purchases aimed at lowering long-term yields may have been partly responsible for this shift.


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