U.S. treasury rates continue to baffle investors. The 10-year yield tends to be one of the most frequently-estimated yet difficult-to-predict data points in the investment landscape. In addition to commercial lending rates, its importance is hinged on it being the general base rate for 30-year fixed residential mortgages.
Normally, interest rates tend to rise as expectations for stronger economic growth, especially if those for inflation do as well. Conversely, falling rates indicate rising fears, slower growth, and/or tempered inflation (all of which can often go together), as market expectations look to more accommodative central bank policy if an erosion in conditions continues. Other factors can be at play also, but these are the general tendencies.
For the 10-year treasury note, recent strategist expectations have called for a rise back toward 2.00% in keeping with stronger inflation numbers and ‘reflating’ growth. The solicitations for ‘rising rate’ financial products have been picking up speed as well. Instead, rates fell to 1.25% last week—the lowest point since mid-February. Often strength in bond prices (and lower yields) is coordinated with equity weakness, as investors move from ‘risk on’ to ‘risk off’ positioning. In this case, though, the equity market has remained robust. Strategists, who often like to have answers to these questions, seem to remain perplexed.
There are a few possible reasons for the rate reversal:
- Growth. The post-pandemic reflationary growth trend may be peaking. As rates and economic growth tend to go together, a flattening of future growth prospects can put a cap on rate expectations. This doesn’t mean ‘bad’ growth, but just a quicker reversion back to normal than previously thought. Above-trend growth is still expected for 2021 and 2022, although some estimates lately have been ticking down by a few tenths of a percent.
- Inflation. As more research on the topic has been dissected, and pricing in some goods has eased, markets appear to be coming around to the thesis that recent price spikes will be ‘transitory,’ in keeping with the Federal Reserve’s description. This is as opposed to the view that recent strong fiscal spending and long monetary accommodation would push future inflation to a sustained higher plateau not seen in since the late 1970s/early 1980s. This debate has not yet resolved, and only time will provide a clearer indication of any inflation persistence into next year and beyond. But, for now, some of the fear has abated.
- Market technicals. Treasuries continue to see strong interest from foreign buyers—due to their reputation as the world’s ‘risk free’ asset, and as their own government sovereigns still offer minimal, zero, or even negative yields. Whenever treasury rates have risen even a bit, this foreign demand has picked up. This has been coupled with regular U.S. treasury operations, which has generated fewer bonds for sale this year. Simply, demand has overwhelmed supply, pushing prices up and yields down. The ‘obvious’ trade of shorting treasury bonds to take advantage of rate increases has been ineffective, so buying to cover these short positions may also be playing a role.
- Hidden bad news, aka ‘the bond market knows something we don’t’. Due to their conservative use in portfolios, and inherent low returns with little room for error, bond markets have often priced in bad news before equity markets do. This could be coupled with the items above, or reflect growing pessimism over further recovery. Growing attention around the Covid ‘delta variant,’ which has proved more contagious (even for some that are vaccinated), seems to be raising some fears about future interruptions in activity or even lockdowns once again
What’s to come? We won’t speculate, as rate forecasts don’t tend to be helpful. Base short-term rates remain lower than average, in fact negative on a real yield basis, in contrast to slightly positive real rates earned historically. A pricing model by credit research firm Moody’s—which incorporates GDP, CPI, the fed funds rate, and Fed balance sheet size—has recently pegged the fair value of the 10-year at 1.60-1.65%. We’ve also seen 1.75% or so quoted as a fair value estimate. Of course, these are lower than the 2%+ rates feared (or hoped for), although conditions are subject to change quickly along with any of the above inputs.
Over time, long-term treasury yields are a function of short-term base rates, with a term spread added, which reflects expectations for inflation and growth (noted earlier). Low short-term rates naturally pull down longer-term bond rates as well, although the steepness of the curve will affect the degree of this. If inflation especially does pick up, it would be reasonable to assume rates would as well, especially if rates start to pick up globally. However, the yield premium for U.S treasuries vs. foreign governments has kept treasury demand high for years.
Estimates of real economic growth after the 2021-22 rebound are estimated to revert back to prior ‘normal’ levels (of around 2%). This is based on demographics/labor force growth and productivity estimates. Based on this factor alone, such tempered growth doesn’t create an environment supportive of strongly higher rates. Inflation remains the wildcard. While supply shortages can be eventually resolved, an environment of fewer workers (rising labor costs) and more dependents could be somewhat inflationary, but how deeply this trickles into CPI remains under debate.
This is another reminder of why it’s not a bad idea to own some traditional fixed income (even government bonds, despite perpetually low yields in recent years), regardless of what the pundits say. Despite the unappealing prospect of locking in a rate of less than 2% for 10 years, treasuries remain one of the least-correlated assets to equities and other risk assets in an asset allocation portfolio in the near-term. These can provide an important buffer if and when volatility hits.