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(Bloomberg Opinion) — Yields on long-term US Treasury securities have risen, and prices have fallen, farther and faster over the past few years than at any time since the 1980s. This has wreaked no small amount of havoc — contributing, for example, to the recent demise of several regional banks.
I have what might be disconcerting news: It’s not over.
Since last fall, the 10-year Treasury yield has remained in a narrow range near its current level of 3.75%. There’s little reason for it to stay there, and many reasons to expect it to move considerably higher.
First, with the economy still strong, the labor market extraordinarily tight and inflation stubbornly high, the Federal Reserve will probably be taking short-term interest rates higher for longer. In their most recent projections, two thirds of officials on the policy-making Federal Open Market Committee saw at least two more 0.25-percentage-point increases this year, while the median forecast was for the federal funds rate to remain above 4% at the end of 2024. They also appear to be increasing their estimate of the “neutral” rate that neither restrains nor boosts the economy, suggesting that a higher fed funds rate will be required to combat any given level of inflation. This makes sense: With baby boomers spending down retirement accounts, the government running large budget deficits and vast capital investments required in supply chains and green technology, higher rates will be necessary to balance demand for borrowing with a shrinking supply of savings.
Second, over time, average inflation — a key component of bond yields — will almost certainly be higher than the Fed’s 2% target. The central bank’s monetary policy framework is asymmetric. When inflation is too low, it wants to compensate by aiming above 2%, lest inflation expectations decline and erode its ability to stimulate growth (if, for example, inflation expectations fell to zero, taking interest rates to the zero lower bound would have little stimulative effect). But when inflation is too high, Fed policymakers merely aim to get back to the 2% target. Over time, the result should be more upside than downside misses.
Third, the bond risk premium — the added yield the government pays over expected future short-term rates — is likely to move higher. For one, investors will demand more compensation for uncertainty about future inflation. Also, given the dim prospects for any political agreement to get the US government’s unsustainable budget deficits under control, the Treasury will be issuing vast amounts of debt — at a time when the Fed will be reducing its Treasury holdings by $60 billion a month, and when international sanctions have led some central banks (notably China and Russia) to reduce their appetite for US Treasury securities.
How high, then, might Treasury yields go? Let’s put together the pieces. Suppose the Fed’s short-term interest-rate target, adjusted for inflation, averages about 1% over the next decade. Inflation averages 2.5%, and the bond risk premium is one percentage point. In sum, this suggests a 10-year Treasury note yield of 4.5%. And that’s a conservative estimate: Given historical neutral short-term rates, the recent persistence of inflation and the troubling US fiscal trajectory, all three elements could easily go higher.
To some extent, this is what the Fed needs to happen, to slow the economy and get inflation under control. That said, it’s been so long since long-term rates have reached such heights that further havoc is all but guaranteed. There’s just one possible silver lining: With any luck, a reawakened bond market might force US politicians to finally get the country’s fiscal house in order. The sooner the better.
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To contact the author of this story:
Bill Dudley at [email protected]
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