What’s going on with the rise in rates?

Since the beginning of August, we’ve seen 10-year U.S. Treasury yields move nearly a full percentage point higher and are now flirting with a 5% handle. Longer-dated bonds have been selling off faster than younger-dated bonds. We’ve seen a deeply inverted yield curve somewhat normalize: the spread between 2-year and 10-year U.S. Treasuries tightened from over 70bps to around 20bps now. What’s driving rates here?

Interest rates are in the driver’s seat this month, so this question remains a fan favorite in our client meetings, and for good reason. We believe long-dated yields have been rising for three main factors: 1) better-than-expected growth, 2) Treasury supply, and 3) rising term premium.

1. U.S. economic growth continues to surprise to the upside. The labor market, retail sales and GDP data have all come in above expectations, pushing real yields higher. All else held equal, stronger-than-expected growth has historically delivered a rise in real yields. Of the 50bps increase in rates since September 20^th, almost all the rise has come in real rates (notably, not via widening inflation breakevens).

2. Simple supply and demand dynamics: a surge of Treasury issuance is needed to fund government spending. From July to December 2023, we expect net Treasury issuance to approach $1.8 trillion in coupons and bills.¹ With so much supply coming to market, it’s fair to ask – who is the marginal buyer of all these Treasuries? Many of the major Treasury buyers have started to trim their holdings – from the Federal Reserve via quantitative tightening to foreign central banks. A shrinking pool of buyers amid heavy supply increases pressure upwards in rates, especially on the long end.

3. Investors are demanding greater returns for holding longer dated bonds. The so-called “term premium” has turned positive for the first time since 2021, in part due to rising U.S. deficits.

You mention term premium, which has been getting quite a bit of headline attention amidst this move. What is term premium and what is its impact here?

Term premium is the compensation investors receive for uncertainty about the path of short rates. Picture this – you just bought a 3-month Treasury bill at issuance. When that bill matures, you reinvest the cash you receive into another 3-month bill, at the new market rate. When that bill matures, you reinvest the proceeds again, and again, and again – for 10 years. Now, compare what you’ve earned by rolling a long series of bills to what you would’ve collected if you had simply bought a 10-year Treasury note to begin with.

If you knew exactly what 3-month rates would be at every point of reinvestment, then the return from both approaches should be identical. But nobody knows the future with certainty, and the less certain the market is about where short-term rates will land in the future, the more yield investors will demand in compensation for locking up their principal at a fixed rate.

A positive and rising term premium is consistent with our preference for moving out of cash and into duration. Since May 2022, the 10-year term premium has been negative, but this phenomenon has now changed – according to one model, the 10-year term premium has climbed over a percentage point since the July FOMC meeting and is finally back in positive territory.

Much has been made lately of the U.S. federal government deficit and the subsequent debt servicing costs that you allude to. How does this come into play?

The current level of Federal spending relative to revenues is unsustainable. In our view, spending must be curbed considerably, or taxes must be raised, or more realistically, both are needed to close the gap. The U.S. primary deficit – the shortfall in government revenues relative to non-debt servicing expenditures - is 5.5% of GDP. The overall or secondary budget balance is -8.2% of GDP.² In essence, the U.S. is borrowing about 2.5% of its GDP to pay the interest on debt that it previously borrowed.

There has been a rapid increase in total U.S. government debt (~8%!) this year, and the cost of financing that debt climbs alongside rates. With over 30% of total outstanding debt maturing in the next 12-months (totaling a whopping ~$8.5tr.), we expect U.S. Treasury auction sizes to increase across the curve in 2024.³ Increasing supply amid more tepid demand results in rates continuing to increase.

Let’s put a bow on this. What is your preference for positioning across the curve in U.S. Treasuries?

Historically, the end of a Fed hiking cycle has spelled good news for bonds. We see an opportunity to move out in duration to take advantage of market repricing that is more closely aligned with Federal Reserve expectations. The belly of the curve, particularly that 5–7-year portion, looks particularly attractive: not only is the return from holding bonds with these durations relatively appealing, but so is the total return in the case of the federal reserve cutting rates.

What do you think it would it take to get you to move further out in the curve?

At current yields, we do not think the risk-reward justifies a move further out the curve. Something would have to change our view. We would need to see 1) the yield curve return to a normal, upward -sloping term structure and 2) a positive level of term premium more consistent with pre-GFC levels. A third development that would be a pronounced slowdown in economic growth and a pricing-in of a substantial risk of recession. In that case, investors could move out in the curve and grab yield wherever they can find it. Until we see that, we remain firm in our preference for the belly of the curve.