The current state of the U.S. bond market signifies a significant juncture, indicating the conclusion of an era characterized by persistently low-interest rates and inflation that originated from the 2008 financial crisis.
10-Year Treasury Yields Jumped to a Record High
The perspective of the market has garnered significant attention in recent days, as there has been a notable surge in 10-year Treasury yields, reaching levels not seen in 16 years.
The rationale behind this decision is rooted in the belief that the disinflationary pressures, which the Federal Reserve addressed through its accommodating monetary measures following the financial crisis, have diminished. This perspective is shared by investors and is supported by an ongoing analysis conducted by the New York Fed, which relies on yield-based indicators to assess the situation.
On the contrary, it is evident that investors have developed a prevailing sentiment that the current state of the U.S. economy potentially aligns with what a regional Federal Reserve president has referred to as a “high-pressure equilibrium.” This state is characterized by inflation surpassing the Federal Reserve’s targeted 2% threshold, accompanied by low unemployment rates and favorable economic growth.
The Transition Into a New Era Is Happening Right Now
According to Greg Whiteley, a portfolio manager at DoubleLine, a transition into a new era has occurred. The endeavor to elevate the inflation rate shall be characterized by something other than arduous exertion. Efforts will be made to ensure a reduction in the level of noise disturbance.
The significant transformation in the perspective on interest rates carries substantial ramifications for policy, business, and individuals. The recent increase in interest rates is perceived favorably by individuals seeking to accumulate savings. However, it is worth noting that enterprises and consumers have grown accustomed to the prevailing trend of negligible borrowing costs over the past decade and a half.
The potential ramifications of transitioning to a prolonged period of higher interest rates may result in significant challenges, such as the possible failure of business models and the increased unaffordability of residential properties and automobiles.
Additionally, this situation may compel the Federal Reserve to persistently increase interest rates, potentially leading to a critical point where a recurrence of adverse events, akin to three regional banks in the United States experiencing significant challenges in March, becomes possible.
In a recent communication, Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, expressed the notion that if the economy is in a state of high-pressure equilibrium, it would be necessary for the Federal Reserve to consider implementing additional rate increases. This could substantially increase rates to effectively mitigate inflation and bring it back to the established target.
A 40% probability was assigned to the scenario above.
Utilizing a market-based Federal Reserve (Fed) model that effectively dissects the 10-year Treasury yield into its constituent elements serves as an additional avenue for comprehending investors’ thought processes.
According to the Adrian, Crump, and Moench (ACM) model, it has been observed that one particular element of yields, which serves as an indicator of the remuneration investors require for lending funds over an extended period, has exhibited a positive trend in recent days. This marks the first occurrence of such a development since June 2021.
The observed increase in term premium, which had persistently remained in negative territory for a significant portion of the previous decade, can be attributed to elevated uncertainty surrounding the economic outlook and monetary policy, as indicated by investors.
Simultaneously, there has been a notable escalation in the second element of yields within the model, about the market’s pricing projections for short-term interest rates a decade from now. This figure has experienced a substantial surge in recent months, currently hovering at approximately 4.5%. The prevailing sentiment among investors indicates a need for more anticipation for significant reductions in the Federal Reserve’s funds rate, presently within the range of 5.25% to 5.50%, over the forthcoming years.
The Possible Rise in Interest Rates Should Not Be Overlooked
The anticipated increase in interest rates has a reciprocal impact on the term premium, which had been maintained at a low level primarily due to the Federal Reserve’s substantial bond purchases aimed at stimulating the economy when conventional rate cuts were no longer feasible due to reaching the zero lower bound.
An anticipated future rate increase would provide the Federal Reserve with greater flexibility to modify policy solely through adjustments in interest rates. Confident investors believe that policymakers may opt to phase out the utilization of quantitative easing as a policy instrument. The Federal Reserve has been divesting its bond holdings, thereby gradually reducing the size of its balance sheet.
According to Emanuel Moench, a professor at the Frankfurt School of Finance and Management and one of the Fed model’s authors, a highly capitalized Treasury investor is gradually departing from the market. The statement above may contribute to an increase in uncertainty regarding the anticipated trajectory of Treasuries.
It’s Like Spitting in the Dark
The elevated short-term rate also indicates that structural transformations, encompassing deglobalization, diminished productivity, and an aging population, have contributed to a high and intangible theoretical interest rate. This rate signifies a point at which economic growth neither hastens nor decelerates while maintaining full employment and price stability. The term commonly employed to refer to this concept is the neutral rate, also known as r-star.
According to John Velis, the forex and macro strategist for the Americas at BNY Mellon, it is likely that the long-term r-star exceeds the estimation of the Federal Reserve. The disinflationary momentum observed during the post-global financial crisis (GFC) era has ceased.
The prevailing sentiment within the market suggests a notable degree of confidence in the anticipated conclusion of the era characterized by zero interest rates. However, this confidence is considerably diminished when it comes to the prospective trajectory of the economy itself.
As an illustrative example, the neutral rate plays a pivotal role in influencing the Federal Reserve’s policy rate adjustments to either moderate or stimulate economic activity. However, the precise determination of this rate will only be achieved once a significant disruption occurs. The estimates exhibit considerable variability.
According to Leslie Falconio, the head of taxable fixed income strategy at UBS Global Wealth Management, a notable challenge associated with the neutral rate is the uncertainty surrounding its determination, which remains elusive until surpassed.
The current era is characterized by a prevailing sense of uncertainty, which also extends to the realm of monetary policymakers. According to a study conducted by the San Francisco Federal Reserve in August, an index was developed to measure the divergence among policymakers regarding their economic forecasts. The findings revealed that this index had surpassed the average levels observed before the onset of the pandemic by June.
According to BNY’s Velis, the prevailing bond market pricing suggests that investors perceive a higher likelihood of a high-pressure equilibrium scenario than the estimation provided by Kashkari.
However, when inquired about the possibility of quantification, Velis refrained from providing a definitive response.