What’s Driving Yields Higher? — Evening Brief – 11.04.24
US federal interest payments as a proportion of GDP continue to climb dramatically. According to data from the second quarter of 2024, payments increased to 3.8%, the highest level since 1998. Despite payments remaining significantly lower than the nearly 5% peak seen in the 1980s, the steep increase is causing concern among the financial market community as yields on government debt have spiked in recent weeks even though the Federal Reserve has embarked on a rate-cutting cycle.
Last week, the US Treasury 10-year yield closed at its highest level of the week at 4.36%, a level not seen in four months, and the trend has gathered pace to begin this week. It was approximately only six weeks ago that the yield was trading over 75 basis points lower at 3.60%. The rise in yields can be partially attributed to the positive economic reports that have been released during this time; however, the fiscal outlook may be more influential than the data at this time.
The U.S. debt-to-GDP ratio, for example, has experienced a significant increase in recent years. After reaching a peak of over 130% during the pandemic, the ratio has since decreased, but it remains significantly higher than the pre-pandemic level, at over 120%.
Determining the precise threshold that will trigger a significant market backlash is a challenging task. For instance, Japan has maintained a higher debt-to-GDP ratio (projected to hit 268% by the end of the year) than the U.S. for an extended period; however, Japan has had no difficulty in the past in terms of debt servicing or bond sales. It is reasonable to assume that the U.S. has a greater amount of debt capacity than Japan.
The recent increase in the 10-year term premium is a clue that suggests a more significant impact from fiscal risk than strong economic data. The estimated 10-year term premium has experienced a substantial spike since the middle of September, resulting in a rise in the 10-year Treasury yield, based on a model developed by Federal Reserve economists (“An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates” by Don H. Kim and Johnathan H. Wright).
Investors are seeking increased compensation for prospective fluctuations in interest rates for intermediate to long-term maturities, a shift in mood that is arguably linked to intensified concerns around fiscal risk.
Additionally, note that the Treasury market’s implied inflation expectations have popped recently, as indicated by the yield differential between the nominal 10-year rate and its inflation-indexed equivalent. On September 10, this spread was just over 2%, increasing to 2.34% by the end of October.
The significant spike in the price of gold is also viewed as a cautionary tale of fiscal irresponsibility. On October 30, the yellow metal traded just above $2,800 per ounce – another record high.
It is important to note that there is a level of conjecture in correlating Treasury yields with fiscal risk. However, it is evident that the government’s fiscal profile has grown increasingly relevant to markets from various viewpoints, and not positively.