The 10-year Treasury yield rose to a new 16-year high on Thursday, as Federal Reserve Chairman Jerome Powell spoke at the Economic Club of New York. Powell said further tightening may be warranted if recent strong economic data continues, but he also noted that “financial conditions have tightened significantly” as longer-term bond yields rise.
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Powell pledged to “move carefully,” signaling no rush to raise interest rates again. In the discussion that followed his opening remarks, Powell discussed the unexpected degree of economic power. “It may be that interest rates have not been high enough for long enough.”
Powell also discussed the new normal for interest rates after a period of very low interest rates following the 2008 financial crisis. Asking himself whether interest rates would return to normal levels between 4% and 5%, Powell said he thought they might end up somewhere in the The middle – between the old normal and the era of extreme decline.
Powell talks about the 10-year Treasury yield
Why did the 10-year Treasury yield rise? “It’s clearly not about expectations of higher inflation,” Powell offered. He also ruled out expectations of short-term Fed policy moves. “This is already happening with term premiums,” he said, which is the compensation investors demand for holding bonds longer.
Powell also attributed the rise to “increasing focus on the fiscal deficit,” adding that “QT could be part of it.”
He said current debt levels are not a concern, but the fiscal trajectory is. “We’re going to have to get out of this way sooner or later.”
While Powell was speaking, the yield on 10-year Treasury bonds reached 4.99%, falling to just 4.95% after he finished speaking. The S&P 500 fluctuated near the flat line, then turned moderately higher, rising 0.4%, after falling 1.3% on Wednesday.
Some of Powell’s colleagues said the rising 10-year Treasury yield, which is a key input for 30-year auto loans and mortgages, as well as valuations for growth stocks, is doing the Fed’s job for it. Powell acknowledged that a rise in the 10-year bond yield could mean “at the margin” less need to raise interest rates.
As of Thursday, markets expect just 4% odds for a quarter-percentage point rate hike on November 1, but those odds rise to 32% for a policy update on December 13 and 42% on January 31.
Supply risk of 10-year Treasury yields
Recently, concerns about the oversupply of Treasuries have increased. The outbreak of war between Israel and Hamas adds to this danger, especially if that war extends. President Biden intends to ask Congress for $100 billion in emergency funds in the coming days to support Israel, Ukraine and Taiwan, as well as to strengthen US border security.
The continuing spectacle of House Republicans being unable to settle on a new president also has implications for Treasury supplies. Kevin McCarthy was demoted after eight Republicans withdrew their support following his agreement to keep the government open. But the Republican Party does not have the votes to insist on strict budget cuts.
Federal Reserve balance sheet
The strong set of economic data highlights another risk — that the Federal Reserve will continue to unload bonds it bought early in the pandemic to boost financial market liquidity. The Fed lets up to $95 billion of Treasuries and mortgage securities off its balance sheet each month.
The latest rally in the 10-year Treasury yield began a week ago, when the core CPI matched expectations for a 0.3% monthly rise, but utility prices came in unexpectedly hot. Then came the September retail sales report on Tuesday, which showed a monthly rise of 0.7% which was more than double expectations even with previous data revised higher. New claims for unemployment benefits during the week of October 14 fell by 13,000 to 198,000, the lowest level since mid-January.
Until the economy deteriorates clearly, the Fed is unlikely to say much about its plans to slow and eventually stop tightening its balance sheet.
US Treasury loans
The Fed’s offer exacerbates US borrowing needs. On July 31, RThe US Treasury surprised Wall Street by announcing its plan to issue $1 trillion worth of debt securities through the public markets in the third quarter. Borrowing estimates were $274 billion higher than announced in May.
Meanwhile, foreign demand for US Treasuries is revealing some gaps. Alan Ruskin, a strategist at Deutsche Bank, wrote that Wednesday’s cross-border financial flows update would only “increase concerns” that China and Japan will not be present in financing the US fiscal deficit. He pointed out that China sold $15 billion worth of US Treasury bonds and bonds, and unlike previous months, it did not compensate for those sales by buying other securities belonging to US government agencies.
The inflation rate at the Treasury’s break-even point
A look under the hood of the 10-year Treasury yield confirms that markets are much more concerned about supply than they are about inflation expectations. Before August 1, the yield on the 10-year Treasury note had only briefly risen above 4%. But since then, the 10-year Treasury yield has risen by 99 basis points, yet inflation expectations have barely changed.
The inflation-compensating portion of the 10-year Treasury yield is known as the 10-year break-even inflation rate. This is derived by subtracting the 10-year TIPS (or inflation-protected securities) rate from the 10-year Treasury yield. Since July 25, the day before Fed Chair Jerome Powell revealed that Fed staff no longer expect a recession, the 10-year inflation rate has risen modestly to 2.49% from 2.39%.
Meanwhile, the 10-year TIPS rate, which takes into account inflation expectations, jumped to 2.47% from 1.53%.
Interest rate shock coming?
The big question here is how strong the impact of higher long-term interest rates on the economy will be, and how quickly it will happen. Already, home mortgage applications have fallen to their lowest level since 1995, with the average 30-year mortgage at 7.7%, the Mortgage Bankers Association reported Wednesday.
The interest rate shock also hits at the same time that federal student loan payments resume after a three-and-a-half-year hiatus. So far in October, mortgage payments are being made at an annual rate of $75 billion above last year’s pace.
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