Evening Brief – 09.28.23
A Powerful Force of Variables
We are witnessing an interesting development in the government bond markets as a powerful force of variables has driven interest rates sharply higher in recent weeks.
On Thursday, the 10-year US Treasury yield reached 4.62%, the highest level since 2007. At the same time, the 2-year Treasury yield, most tied to Federal Reserve monetary policy, hit 5.15% on Wednesday; only a whisper below its peak of 5.16% seen in July 2006.
I can think of four factors, although there are probably more, boosting yields, which will likely continue to rise until one or more of the catalysts undergoes a significant change.
First, the preliminary estimate of US GDP for the fourth quarter, which will be revealed next month, is projected to exceed 3%. If this is the case, economic activity will pick up significantly from the 2%-plus pace seen in the second quarter. To that extent, yields are likely to keep rising.
Second, the Fed is projected to maintain its aggressive policy stance for some time. While forecasts differ on whether the central bank will raise interest rates on November 1, the broad consensus is that interest rate cuts, as reflected in the CME FedWatch Tool, are unlikely to materialize until well into next year.
As a result, the Fed is in a position where simply maintaining its monetary stance equates to passive tightening. Notably, the 2-year yield is bridging the gap with the Fed funds rate as the market acknowledges that the central bank’s policy rate may remain higher for longer.
A major element is how inflation performs in the coming months. Although pricing pressure has eased significantly since last year’s peak, there are concerns that inflation may settle around 3%, still above the Fed’s 2% target.
Minneapolis Fed President Neel Kashkari estimates a 40% probability that interest rates will continue to rise to tame inflation. In an essay published earlier this week he wrote that a “high-pressure equilibrium” is settling over the US economy that will keep inflation well above the Fed’s 2% inflation target.
Third, energy costs are skyrocketing. Although central banks tend to focus on core inflation, which excludes energy and food, headline prices remain an issue. The current crude oil rally threatens to stop and possibly reverse the disinflationary trend for headline inflation indicators.
Fourth, investors are dealing with a deluge of debt issuance. At the end of July Treasury announced it expected to borrow $1.007 trillion in the third quarter, sharply more than the estimate in May of $274 billion and highest ever for a third quarter. Of course, there will be buyers but at what price?
The growing US budget deficit, along with the possibility of a government shutdown beginning October 1, is raising concerns that rising Treasury debt sales will weigh on prices and drive yields higher.
Keeping an eye on these factors is essential for managing bond market expectations.