Posted by Lawrence Gillum, CFA, Chief Fixed Income Strategist

Wednesday, October 4, 2023

U.S. Treasury yields have seemingly been moving in one direction lately (higher) with news overnight that the 30-year Treasury yield touched 5% for the first time since 2007. The move higher in yields (lower in price) has been unrelenting with intermediate and longer term Treasury yields bearing the brunt of the move. The large move in yields is naturally generating several questions from investors such as:

• How much higher can rates go? Certainly, this is the $64,000 question, but in our view Treasury yields are moving on both fundamental and technical reasons (more on this later) but the momentum is clearly higher yields. Our Chief Technical Strategist, Adam Turnquist, has identified 5.25% to 5.50% on the 10-year yield as possibilities now that we’ve broken above 4.7% (although the next level of resistance is at 4.9%). Moreover, the Treasury yield curve remains inverted so as the probabilities of a recession continue to get priced out, we could continue to see the prospects of a more normal, flat, or even upward sloping yield curve, which would mean 10-year yields could get to those 5.25% levels. Our base case is the economy slows towards the end of the year and into 2024 so that could take pressure off yields, but in the meantime, momentum is in the driver’s seat.
• What is driving yields higher? There are a number of reasons we’re seeing higher yields, but rates are moving higher alongside a U.S. economy that has continued to outperform expectations, pushing recession expectations out further, and by the unwinding of rate cut expectations by the Federal Reserve (Fed) to be more in line with the Fed’s “higher for longer” regime. Additionally, the U.S. government is expected to run meaningful deficits over the next decade, which means the Treasury department is going to have to issue a lot of Treasury debt to cover those deficits at the same time the largest owners of Treasury securities are reducing their holdings (LPL advisors: we wrote about America’s debt problem and the supply/demand dynamics in the most recent Rate and Credit View). This supply/demand problem is causing fixed income investors to demand additional compensation for owning longer maturity Treasury securities, which is pushing up yields.
• Some are predicting 10% or even 13% on the 10-year; is that realistic? While we aren’t ruling anything out at this point, we think it would take a significant reacceleration in inflation and thus a significantly higher fed funds rate than what we currently have. Perhaps lost within these double-digit predictions that take us back to Treasury levels last seen in the 1980s, is that Treasury yields, by and large, tend to be tethered to the fed funds rate. So, to get back to 10% or 13% Treasury yields, the fed funds rate would need to be in double digits as well. And with inflationary pressures trending in the right direction (albeit slower than expected) we don’t think the Fed needs to take the fed funds rate up to double digit levels.

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• But what if that does happen and we see 10% Treasury yields? Treasury yields are viewed by many as the risk-free rate and as such are used as the base rate for a number of consumer and corporate loans. So, when Treasury yields increase, the costs to borrow increases as well. For example, the recent increase in the 10-year Treasury yield has pushed mortgage rates to 7.5%—levels last seen in 2000. Credit card rates, new auto loan rates, and newly issued corporate debt are all now more expensive than they were a year ago because of rising Treasury yields. That is likely going to impact consumer spending. Paradoxically perhaps, as the bond market prices out a recession with higher yields, the chances of a recession could actually be increasing due to higher borrowing costs.
• What about the credit markets? Are cracks emerging there as well? The corporate credit markets, particularly the high yield market, have been surprisingly resilient in the face of one of the most aggressive rate hiking campaigns in decades, tightening of lending standards, and the increase in defaults (we wrote about the high yield market in a recent blog post here) but we are starting to see signs, albeit small ones, that the credit markets may be turning. It’s too early to call this a trend but over the past few weeks we have seen spreads (the additional compensation for owning risky debt) increase. Now to be fair, spreads are still below historical averages but the speed with which the spread widening has taken place is a yellow flag that we’re watching closely. The riskier credit markets have been priced to perfection so we haven’t liked the risk/reward for those markets and if the economy does slow we could see spreads widen from current levels as well.
• I’m ok with the near-term volatility so how do I take advantage of these higher yields? With yields back to levels last seen over a decade ago, we think bonds are an attractive asset class again. There are three primary reasons to own fixed income: diversification, liquidity, and income. And with the increase in yields recently, fixed income is providing income again. Right now, investors can build a high-quality fixed income portfolio of U.S. Treasury securities, AAA-rated Agency mortgage-backed securities (MBS), and short maturity investment grade corporates that can generate attractive income. Investors don’t have to “reach for yield” anymore by taking on a lot of risk to meet their income needs. And for those investors concerned about still higher yields, laddered portfolios and individual bonds held to maturity are ways to take advantage of these higher yields (LPL advisors: make sure you check out the corporate credit focus list for individual credit names that may be worth a look).

The move higher in yields recently has been unrelenting but we think we’re closer to the end of this sell-off than the beginning. Over the past decade, interest rates were at very low levels by historical standards. Now, the recent sell-off has taken us back to longer term averages. That is, at current levels, yields are back to within normal ranges. And while the transition out of the low interest rate environment to this more normal range has been a challenging one for fixed income investors, we think the prospects for the asset class have improved and the longer yields stay at these elevated levels, the more enduring the asset class becomes.

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