Understanding Higher Yields 

10.11.2023 The 10-year Treasury yield plunged more than 10bps, to around 4.7 per cent, on Tuesday morning in response to Hamas’s surprise attack on Israel over the weekend. The move was a stark reversal of a steady climb in intermediate yields since the summer. The Treasury benchmark note reached 4.8 per cent last week, its highest yield since August 2007 and about 0.8 per cent higher since the end of July. It was the biggest two-month yield increase of the year and, like the rate move last year, it rippled through the financial markets.

10-Year US Treasury Yield

The spike in rates quashed an equity rally which began late last year, as interest rate-sensitive equities found themselves suddenly overvalued relative to bonds. The S&P 500 fell nearly eight per cent in response to the higher yields, with high-quality stocks shedding a little more than three per cent.  International equities fell incrementally farther, due to dollar strength. Higher rates have boosted the greenback by about five per cent since the beginning of August. The most recent bond rout also threatens investors’ hopes for a “soft landing,” an environment in which the Fed is able to guide inflation back to its two per cent target rate without an economic recession. Higher rates have stultified the housing market by pushing mortgage borrowing rates to their highest level in 23 years. Existing home sales have retreated by more than one third from the pandemic buying binge in late 2020.

US Housing Market: New and Existing Home Sales

The most recent rate spike appears at odds with a central bank in the process of wrapping up its tightening program against a backdrop of slowing inflation. A recent uptick in growth on strong consumer spending suggests the neutral rate that neither stimulates nor slows the economy might be higher than investors previously thought. A stronger-than-expected September jobs report underscored the trend. However, credit delinquency rates are on the rise, particularly on credit card and auto loans, suggesting that consumers’ summer strength is weakening. 

US Composite Credit Card Delinquency Rates

Another rationale behind the trend in higher rates could be investors’ response to the federal government’s recent fiscal dysfunction. Rating agency Fitch was the latest to downgrade US government debt to AA+ on governance concerns. Congress narrowly avoided a government shutdown and has extended the budget deadline by 45 days, although the House is without a leader. Meanwhile, US government debt issuance is on the rise, thanks to unprecedented deficit spending. It’s remarkable that the timing of gaping deficits coincides with low unemployment. Historically, fiscal policy served as a counterbalance to the economy, running deficits during tough times and surpluses in prosperity. History suggests we should have run a two per cent deficit last year, based on the historical relationship between deficits and the unemployment rate. Instead, the federal deficit is projected to reach $2.85 trillion by 2033, cumulatively totaling $20.2 trillion, or 6.1 per cent of GDP, according to the Congressional Budget Office. That’s well above the 3.6 per cent average over the last 50 years.

US Federal Budge Deficit vs US Unemployment Rate 2001-Today

As a result, the government has been forced to ratchet up borrowing. The US Treasury surprised investors earlier this year by announcing it would borrow roughly $1 trillion in the current quarter. At the same time, demand for US debt is falling due to lower global trade activity. The central banks of Brazil, China, Japan and Saudi Arabia have halted their US bond purchases. Japan cut its Treasury holdings to their lowest level since 2019, according to The Wall Street Journal. Compounding matters, the Federal Reserve has been selling its Treasury holding as part of its balance sheet reduction program. The Fed began selling its Treasurys in June 2022, and to date has sold nearly $1 trillion of their holdings. 

Foreign Purchases of US Treasury Securities vs issuance ($bn)

Bottom Line: The publicly held debt of the US has doubled to around $26 trillion over the last eight years, according to The Wall Street Journal. While US holders are filling the void, they’re demanding a higher yield premium to hold US Treasurys. The real yield – the premium over inflation paid by the government to bondholders – is on the rise. The 10-year real yield is currently zero, up from negative two percent a few months ago. Excessive spending and borrowing puts the economy in jeopardy of a recession as government borrowing “crowds out” private access to capital.

10-Year Real Yield vs US Budget Deficit (in $bn)
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