What Is Happening in the Treasury Market and Why Interest Rates Have Moved Higher

Lawrence Gillum (00:00):

U.S. Treasury yields have been seemingly moving in one direction lately, which is higher, with a 30-year treasury yield temporarily breaching 5% for the first time since 2007. The move higher in yields lower in price has been unrelenting, with intermediate and longer term treasury yields bearing the brunt of the move. The large move in yields is naturally generating several questions from investors. So in this edition of the LPL Street View, we answer some of the most important questions we've been getting as to why interest rates have moved higher. U.S. Treasury yields have surged higher recently with the 10-year treasury yield up nearly 1.5% since May. And while there's been a retracement recently at around 4.5% as of the recording of this video, 10-year yields are still around levels last seen in 2007 and are up over 4% since the all time lows back in 2020.

Lawrence Gillum (00:53):

The big move in yields has investors asking questions such as what is driving yields higher. There are a number of reasons we're seeing higher yields, but rates are moving higher alongside a U.S. Economy that has continued to outperform expectations, pushing recession expectations out further and by the unwinding of rate cut expectations by the Federal Reserve to be more in line with the fed's higher-for-longer regime. Now while there has been a noticeable weakness in the most interest rate-sensitive parts of the economy, most notably housing, the broader economy has been surprisingly resilient despite an overly aggressive Fed. This chart compares the Bloomberg Economic Surprise Index and the 10-year treasury yield. The index includes economic data on things like the labor market, retail salesand the personal household sector to name a few. And since May, the economic data broadly has surprised to the upside pushing out prospects of an economic slowdown, which has pushed treasury yields higher as well.

Lawrence Gillum (01:56):

Now additionally, the U.S. Government is expected to run meaningful deficits over the next decade, which means the Treasury Department is going to have to issue a lot of treasury debt to cover those deficits. At the same time, the largest owner of treasury securities are reducing their holdings. This supply-demand problem is causing fixed income investors to demand additional compensation for owning longer maturity Treasury securities, which is pushing up yields. Another question that we get is how much higher can rates go? Certainly this is the $64,000 question, but in our view, treasury yields are moving on both fundamental and technical reasons. And our Chief Technical Strategist, Adam Turnquist, has identified 5.25 to 5.5% on the 10-year as possibilities, although the next levels of resistance are at 4.7 and 4.9%, and the treasury yield curve remains inverted. So as the probabilities of a recession continue to get priced out, we could continue to see the prospects of a more normal flat or even upward sloping yield curve, which would mean the 10-year yields could get back to those 5.25% levels.

Lawrence Gillum (03:04):

Now our base case is the economy slows towards the end of the year and into 2024, so that could take pressure off yields, but in the meantime, momentum is clearly in the driver's seat. Now some are predicting 10% or even 13% on the 10-year. Is that really realistic? Well, we're not ruling anything out at this point, but we do think it would take a significant re-acceleration in inflation, and thus a significantly higher Fed funds rate than what we have currently. Perhaps lost within these double-digit predictions that take us back to treasury levels last seen in the 1980s, is that treasury yields by and large tend to be tethered to the Fed funds rate. So to get back to 10% or 13% treasury yields, the Fed funds rate would need to be in double-digits as well. And with inflationary pressures trending in the right direction, albeit slower than expected, we don't think the Fed needs to take the Fed funds rate up to double-digit levels.

Lawrence Gillum (04:01):

Now, some are asking what if that does happen and we see 10% treasury yields? Well, treasury yields are viewed by many as the risk-free rate, and as such are used as the base rate for a number of consumer and corporate loans. So when treasury yields increase, the cost to borrow increases as well. For example, the recent increase in the 10-year treasury yield has pushed mortgage rates close to 8%, levels last seen in 2000. Credit card rates, new auto loans, and newly issued corporate debt are all now more expensive than they were a year ago. Because of the rise in treasury yields, that is likely going to impact consumer spending. Paradoxically, perhaps as the bond market prices out a recession with higher yields, the chances of a recession could actually be increasing due to higher borrowing costs. Another important question that we're getting is that if you're okay with the near-term volatility, how does one take advantage of these higher yields?

Lawrence Gillum (04:56):

Now, with yields back to levels last seen over a decade ago, we think bonds are an attractive asset class. Again, there are three primary reasons to own fixed income: diversification, liquidity, and income. And with the increase in yields recently, fixed income is providing income again. Right now, investors can build a high quality fixed income portfolio of U.S. Treasury securities, AAA rated agency, mortgage-backed securities, and short maturity investment grade corporates that can generate attractive income. Investors don't have to reach free yield anymore by taking on a lot of risk to meet those income needs. And those investors concerned about still higher yields, laddered portfolios, and individual bonds held to maturity are ways to take advantage of these higher yields. Look, the move higher in yields recently has been unrelenting, but we think we're closer to the end of this sell off than the beginning. Over the past decade, interest rates were at very low levels by historical standards, and now the recent sell-off has taken us back to longer-term averages. That is, at current levels,

Lawrence Gillum (05:57):

Yields are back to within normal ranges. And while the transition out of the low interest rate environment to this more normal range has been challenging for fixed income investors, we think the prospects for the asset class have improved. And the longer yields stay at these elevated levels, the more enduring the asset class becomes. Thanks for listening.