The latest developments in the rates markets globally are a reminder that a return to normal still has a long way to go. The resilience in both inflation and growth is reinforcing the higher-for-longer (HFL) stances of central banks even as financial and geopolitical shocks loom over the outlook.
Specifically, the movement in UST yields (longer-term) has been material in DMs. We have long argued that higher interest rates are a key part of the new regime, as supply constraints may make inflation persistent, while bond supply is swelling due to high deficits, and macro and geopolitical volatility abounds. The US 2s10s yield curve has continued to steepen at one of the fastest paces over the past decade, with UST10Y now crossing the 2007 peak.
The recent surge in nominal long-end yields has been led by: (1) higher supply in recent quarters, (2) higher real yields (which rose as markets faded recession risks) contributing more than inflation expectations (which have trended down amid negative inflation surprises in recent months), and (3) Fed repricing and soft landing narrative leading to higher term premia. The term premium appears to be positive for the first time since 2017.
Key factors that could keep the rates higher
1. Growth resilience: Among other factors, a resilient US economy and higher than estimated excess savings could be growth supportive for the US economy despite tighter monetary stance. Clearly, massive rate hikes over the past 18 months have not yet impacted HHs and businesses meaningfully, with their spending keeping the economy more robust than previously expected.
The recent data revision by BEA meant that the leftover excess saving stood at around $0.7-0.8tn in 2Q, notably higher than the $0.2-0.3tn figure estimated based on pre-revision data.Besides, the labor market also remains tight. JOLTS data shows job openings/unemployed ratio is still much higher than pre-Covid levels despite correcting. Structurally, Labor participation rate has remained below pre-Covid levels, which itself is much lower than pre-GFC levels.
Separately, housing is turning into a persistent problem. A variety of factors has supported the housing market this cycle. Some are structural, such as under-building of homes in the US over the years and increasing household formation. The supply of existing homes has dropped sharply as potential sellers back away because they want to hold onto existing low mortgage rates.These factors suggest inflation is still a threat, and the Fed will have to crush consumption or the labor market—or both—to bring inflation back to target, which translates to a floor under rates for a while. While the academic debate on R* (equilibrium real rate) has been brewing, we note that this cycle has seen the real policy terminal rate lower than past cycles.
2. Higher expected inflation volatility: Structurally higher volatility in inflation, such as from climate-related supply disruptions, greenflation, AI, ageing population or geopolitical flare-ups. If these indeed turn out to be the case, there will likely be less certainty around long-term rates, that deserves more of a term premium. Besides, a multitude of shocks have to be confronted concurrently. In terms of growth, post-pandemic scarring, wars, inflation, rate spikes & climate change; all need to be dealt with agility.
3. Surge of US debt that could see fewer buyers: The net Treasury issuance in FY23 is 2nd highest on record, though well short of the record flood in 2020. The traditional US banking system is funding itself through reserves rather than Treasuries, and foreign buyers may be pulling away as well. With deficit sustainability remaining an issue, the price of fiscal money likely stays elevated.
Where does the endgame lie?
Is 5%++ for UST10Y the new reality?
Supply constraints make inflation persistent- bond supply is swelling due to high deficits; and macro and geopolitical volatility abound.We think the yield surge driven by expected policy rates is nearing a peak. But rising term premium will likely be the next driver of higher yields, led by greater macro volatility, persistent inflation plus large fiscal deficits and debt issuances, which means that 5%++ is not really elusive for 10-yr UST yield.
Interestingly, even with high geopolitical risks, the conventional safe haven status of UST hasn’t played out this time, depicting how focused investors are on H4L and worsening supply dynamics.In order to see an end to the sell-off in the long-end of the curve, some combination of these is needed: (i) economic data deterioration; (ii) tighter financial conditions; (iii) positioning; (iv) cheaper valuations; (v) a shift in Fed policy stance, e.g., Fed becoming less hawkish; and (vi) new sources of Treasury demand emerging. Generally, the Fed is content to let the bear steepening do its job and as the Fed remains patient, the curve is likely to continue to bear steepen. However, if one sees supply/demand imbalances as the primary culprit behind this recent move in yields, then the structural trends may not be too supportive.
That said, there is also a good chance that in the near term Treasury yields swing in either direction or see two-way volatility ahead. Softer policy tone and “politics of inflation” (dominance of growth over inflation) may ease off some pressure in the near term. But overall, supposedly a higher R* implies US economic growth can persist even with relatively high short-term rates, reinforcing Higher for longer.
Madhavi Arora is the lead economist at Emkay Global Institutional Equities desk. She spearheads the Macro research for India and major developed and emerging nations, focusing on policy arena, FX and rates and asset allocation strategies