There was a lot of drama in Treasurys last week. 10-year obligations, trading at a 4.16% yield prior to market open Monday, surged to over 4.32% intra-day on Thursday, the highest level since November 2007. Most of the increase in yield occurred after the release of Fed Minutes on Wednesday. 10-year Treasurys closed the week at 4.25%, below Thursday’s peak but still up from Monday. Just as impressive in terms of market change, NASDAQ, the equity index most sensitive to interest rate movements, had its third successive weekly loss for the first time since December.
What caused the equity selloff, and how high can long-dated Treasury yields go?
A key instigator of the correction in equities and bonds was the message investors took away from the Fed’s decisions and its explanation from the meeting three weeks earlier. Minutes of the Federal Open Markets Committee meeting held on July 25 -26 that were released Wednesday suggested renewed caution on the part of monetary officials. They feared that inflation could continue at levels higher than the Federal Reserve’s target of 2% for much longer.
The implication of higher inflation expectations was that the Fed would have to prepare for even higher interest rates during coming months. That was enough to spook investors who had thought that they had witnessed the end of Fed tightening with the 0.25% increase in the Federal Funds rate announced on July 26.
The swiftness of the move up in bond yields is explained by a number of related factors. First, the belief in “immaculate disinflation” — aka “no landing” —had been taking hold, leading some market players to believe that inflation could continue on its recent downward trend without causing much pain in terms of unemployment or business failures. Readers of SriKonomics will recall that I have been saying that inflation is likely to remain “sticky”, and that a further deceleration will require something “breaking” in the system.
Second, most investors are convinced that the Fed will persist with its anti-inflation fight just as Federal Reserve Chairman Jerome Powell has repeatedly indicated. He has explained that he shares the pain of low- and middle-income families encountering higher prices for basic necessities, and that he and his colleagues will continue to take measures to lower inflation.
On the other hand, I have believed, and still do, that the Fed’s fight against inflation will last only as long as the central bank is not pulled away from its task in order to “save the system.” Recall how the failure of Lehman Brothers in September 2008, whose widespread implications the Fed and the US Treasury had failed to anticipate, led the central bank to open the flood gates of monetary policy. In today’s context, a new “credit event” prompted by the cumulative 5 1/4 percentage point increase in interest rates since March 2022 could mark the end of inflation mitigation being the principal objective.
A current example: In the first half of March, the failure of three regional banks had the Fed switch overnight from Quantitative Tightening to Quantitative Easing as it provided “emergency loans” to the banking system, taking the balance sheet back to the November 2022 level. In just a few days, the banking crisis had wiped out roughly four months of QT.
There are a number of developments vying to become the next “credit event.” The US banking system, that had $515 billion of loans under water at the end of the first quarter according to the Federal Deposit Insurance Corporation, is worse off today with long-dated Treasury yields even higher than at the end of March. The regional banking crisis is not over, and threatens to rear its head if bond yields increase further. That, in turn, should put a ceiling on bond yields.
Another candidate that threatens to become a “credit event” is the worsening commercial real estate outlook as long-dated debt rises in yield. As both Moody’s Investor Service and Fitch Ratings have indicated recently, the banking system appears to be vulnerable on several grounds, with loans to office space being only one of them. Fitch has cut its assessment of the entire US banking system — including some of the largest banks.
If a significant crack appears in the banking sector, look for Powell and his colleagues to “pause” — for ever? — the fight against inflation irrespective of the divergence between the actual and targeted inflation rates.
A note from history on the impact of high long-term yields. The yield on 10-year Treasurys was roughly halved by the start of 2009 after it peaked at 4.32% in November 2007, prompted by the Great Recession that began the following month.
If domestic developments were not sufficient to raise the Federal Reserve’s concern, there is the rapidly deteriorating economic situation in China. The world’s second largest economy is likely to curtail imports, slowing economies that are its major providers. The worsening property crisis means that real estate developers are likely to transmit their financial difficulties to lending institutions. If the Chinese developments put a dent on global economic growth, expect capital flows to seek refuge in US Treasurys.
Bottom line: We may be at, or near, the peak of US Treasury yields for this cycle. Fundamentals do not support pessimists’ call for the 10-year yield to crest at a much higher level.
A higher yield may end up being its own undoing.
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
August 19, 2023
Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.
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