The nation’s inflation problem is far from solved, and the Federal Reserve remains committed to keeping short-term interest rates elevated. But longer-term government bonds may finally be worth a second look after some 14 months of carnage.
Although the Fed has short rates pinned in the vicinity of 4% to 5%, longer-term yields tend to start falling much sooner as monetary tightening cycles come to an end, especially as markets look ahead to the risk of a looming recession. In fact, during the past five rate-increase cycles, 10-year notes have on average peaked and begun to rally 206 days before the first Fed cut. Here’s the basis-point change in the 10-year Treasury in the 12 months before each rate reduction:
In other words, longer-term yields can probably decline from current levels even as the Fed keeps its target rate elevated, provided inflation continues to moderate. The latest consumer price index report showed that core inflation is running at around 5.8% based on the three-month annualized rate. Although noisy, the latest data may provide some support for that argument, and traders on Thursday were in full-on glass-half-full mode, pushing yields down 24 basis points, the biggest one-day drop since March 2020. Here are a few possible paths to consider for longer-term Treasuries.
Bull Case
One simplistic way to think about the fair-value yield on a 10-year Treasury is as the average of the expected yields on 10 one-year bills bought over the next decade. Assume, for instance, that you think yields on 12-month securities will average 5% in 2023, 4% in 2024 and 3% in 2025 — only a slight simplification of the prevailing thinking in markets. After that, you think rates will converge on the long-run “neutral” level of 2.5% on the federal funds rate, according to the median estimate of the members of the Fed’s rate-setting committee. That scenario yields an implied fair-value yield of around 3% on 10-year notes, 84 basis points below the current 3.84%.
You can come up with countless hypotheticals, but most will lead to a similar place. Maybe you think the world is somewhat more susceptible to inflationary flare-ups than it was before the pandemic, in part because of geopolitical unrest and the threat of climate change. As a result, you pencil in another big inflation spike and restrictive monetary policy from 2029 to 2031. Maybe you think, for a variety of reasons, that the long-run neutral rate has moved up to 3% instead of 2.5%. Even then, it’s still hard to justify a 10-year rate above 4%. To get there, you’d have to integrate pretty extreme inflationary scenarios that almost no one is talking about publicly.
The other thing to remember is that Treasuries benefit from a flight to safety. If the world economy tumbles into a recession in the coming 24 months, Treasuries will be in high demand, and yields could drop precipitously as a result.
Neutral Case
In practice, however, market pricing is usually more complicated than the simplistic analysis above, and it’s rare that longer-term rates become completely untethered from their short-term brethren. Ten-year notes can certainly rally in advance of two-year or 12-month securities, resulting in greater and greater yield-curve inversion. But they almost never become unmoored over longer time horizons. In fact, longer-term bonds usually yield more than short-term ones — they pay a so-called term premium — to compensate for the risk of holding them into an unknowable future.
Extreme yield-curve inversion is rare. The 57-basis-point inversion in the two-year/10-year yield differential on Nov. 3 marked the deepest since February 1982. The closest comparison before then was the April 2000 inversion that coincided with the start of the dot-com bust.
In fairness, it’s possible that the 1970s and early 1980s are the only valid comparison to today’s economy because the US hasn’t faced inflation like this ever since. Notably, there were days in 1980 when the curve inverted as much as 242 basis points. But those periods were vanishingly brief and may have simply reflected liquidity differences at different parts of the curve: Traders used the 10-year part of the curve to reflect a view that couldn’t be expressed elsewhere. Archived notes from the Federal Open Market Committee’s March 1980 meeting described the “very thin, almost nonfunctioning markets” that prevailed at the time of the extreme inversion, raising questions about whether that yield curve could be trusted or replicated in 2022’s market.
If you don’t believe the yield curve can withstand much more inversion, then the bull case for longer-term yields is probably somewhat limited with short-term bonds boxed in at current levels.
The other consideration is the Fed, which wants longer-term rates to remain restrictive to limit demand and depress inflation; it has the tools to bring markets to heel if it decides to use them. As Fed Chair Jerome Powell put it at his press conference on Nov. 2, the central bank is not just narrowly focused on the policy rate but also on bonds at all maturities.
We’ll want to get the policy rate to a level where the real interest rate is positive. We’ll want to do that. I do not think of it as the single and only touchstone though. I think you put some weight on that, you also put some weight on rates across the curve. Very few people borrow at the short end, at the federal funds rate for example ...
Powell didn’t explicitly say what he considers to be appropriate longer-term yields. But suffice it to say, his comments suggest he may not look approvingly on any significant rally in longer-term securities, given his stated objectives. If he comes to that conclusion, he can use future press conferences to jawbone yields back into line. And if it comes to it, he could accelerate the pace of so-called quantitative tightening by actively selling Treasuries from the Fed’s portfolio instead of simply letting them mature.
What’s the Bear Case?
These are the scenarios that are easiest to imagine. But importantly, neither one of them is terrible.
You have to get creatively gloomy to envision a future in which long-term bond yields go much higher from here, which is not to say that it’s impossible. You have to believe, for instance, that inflation expectations have become truly unanchored and that the US is heading for a wage-price spiral — that inflation has infected the national mindset and workers will start demanding raises, which employers will reluctantly deliver by raising prices. Not only that, but you have to assume that the Fed lacks the spine or tools to address the problem.
That’s not my assumption, but it’s a defensible argument. In the absence of such thinking, the risk-reward teeter-totter that investors care so much about has started to look relatively decent at current longer-term Treasury yields. Given the carnage that the bond market has just been through and the various perils facing other asset classes ahead of a possible recession, traders may be happy just to invest in an asset that they can reasonably predict won’t lead to any more losses.
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