US Treasury yields have been climbing higher in recent weeks, with the benchmark 10-year yield surging to over 4.9% on Wednesday – its highest level since 2007. This relentless rise in bond yields reflects growing angst in financial markets about several key issues: the Federal Reserve’s monetary tightening path, stubbornly high inflation, bulging government borrowing needs, and recession risks.
As we analyze this bond market turmoil, it is clear traders are bracing for an extended period of restrictive financial conditions as the Fed seeks to tame inflationary forces. Despite nascent signs of economic slowdown, markets believe the Fed will keep interest rates elevated for longer to rein in high inflation before contemplating rate cuts. This has led to a repricing of rate hike expectations and a surge in yields.
Hawkish Fed Expectations Driving Yields Higher
At the crux of the bond market’s turmoil is an evolving recognition that the Federal Reserve has essentially prioritized inflation-fighting over growth, and will maintain higher interest rates for longer regardless of looming recession risks.
Recent hawkish rhetoric from Fed officials has reinforced this narrative. Despite market hopes for a potential policy pivot early next year, the Fed has sounded unequivocal about its commitment to bring inflation back down to its 2% target. New York Fed President John Williams summed up this stance, noting rates will need to stay high for “a few years” to control price pressures.
Traders have responded by materially pulling forward rate hike expectations and pushing out the timing of future cuts. Fed funds futures now reflect rates peaking above 5% by May 2023, and staying near those elevated levels throughout next year. In fact, markets have now priced in a terminal rate near 5.15% – a huge upward revision from 4.5% just a month ago.
This dramatic repricing indicates investors have reluctantly accepted the Fed’s messaging: that rates are heading higher, and coming down slowly. The repricing has fueled the surge in Treasury yields across the curve. Until concrete disinflation is evident, markets see no dovish pivot on the horizon.
Inflation Showing Renewed Signs of Persistence
Markets are also growing concerned that high inflation may be more persistent than hoped. Lately, price pressures have shown renewed signs of broadening out and becoming entrenched in the economy. Tuesday’s red-hot PPI print and stubbornly high shelter and wage inflation underscored these risks.
With the Fed signaling tolerance for “modestly” above-target inflation for now, bond investors fear interest rates may need to stay higher for longer just to keep inflation near 3%. This diminishes hopes for any rapid policy easing or inflation-driven bond rally.
Instead, traders have accepted that monetary policy may remain restrictive even in a slowdown, limiting the Fed’s ability to respond preemptively to recession risks. With inflation still way above target, the Fed has essentially signaled its willingness to err on the side of tight policy. This has fueled the surge in yields.
Government Borrowing Needs Set to Balloon
Apart from hawkish Fed expectations, ballooning government borrowing is also spooking bond investors and lifting yields. With trillion-dollar deficits poised to persist, Treasury debt auctions are set to ramp up significantly to fund government spending priorities.
Analysts estimate the Treasury may need to issue over $2 trillion in net new debt in 2023 to cover the rising deficit. This wall of new bond supply could weigh on prices and drive yields higher, sparking concerns about indigestion in bond markets.
The looming debt ceiling increase – projected at $3 trillion – will allow even more Treasury issuance later in 2023. This prodigious borrowing, in conjunction with Fed balance sheet reduction, threatens to overwhelm private bond market demand.
The risk is that huge auction sizes may require higher yields to entice buyers. Unless demand rises commensurately, the deluge of new issuance could exert enduring upward pressure on yields.
Growth Resilience Fading, Risk of Stagnation Rising
While some still see resilient growth ahead, signs are emerging that markets now seriously consider risks of economic stagnation in the US. Despite isolated data points, momentum continues slowing amid still-high inflation and borrowing costs.
Markets seem concerned restrictive monetary policy may tip the economy into a period of weak and uneven growth rather than collapse. But more worrying is the risk of stagflation – where activity stalls out but inflation remains stubbornly high.
This scenario would leave the Fed unable to pivot dovishly despite stagnation. With inflation still elevated, the Fed may have to tighten further or even hold policy restrictive, even if growth stagnates.
In essence, markets appear to be bracing for a policy-induced stagnation rather than continued resilience. This is diminishing any hopes of Fed easing returning soon.
Yield Curve Inversion Signals Stagflation Concerns
Many now see the inversion of the 2s10s yield curve as reflecting growing fears of stagflation rather than just weak growth.
Markets worry growth is slowing but inflation will remain entrenched, leaving the Fed unable to stimulate the economy without worsening inflation.
This stagflation angst suggests curve inversion is now driven more by concerns over lost Fed space rather than growth fears alone. With inflation still high, inversion may not affect Fed tightening resolve yet.
Instead, bond markets seem concerned about impending uneven growth and persistent inflation – a stagflationary mix. This possibility makes investors reluctant to bet on Fed accommodation reviving growth soon.
Faced with rising risks of stagnation and continued price pressures, markets are unwilling to anticipate dovish Fed easing. This stagflation anxiety looks set to keep yields elevated for now.
The Path of Least Resistance is Higher Yields
In summary, the confluence of hawkish Fed policy, high inflation inertia, massive bond issuance, and perceived economic resilience all signal that the path of least resistance remains higher yields.
Markets are bracing for an extended plateau of restrictive monetary policy, even in a slowdown. Until inflation pressures abate meaningfully, the Fed appears willing to risk downturn.
This implies yields may face sustained upward pressure as the Fed keeps real rates deeply negative to bring inflation decisively down to target.
While recession risks are rising, markets do not seem confident enough to bet aggressively against Fed tightening until material economic weakness emerges.
For now, the relentless forces of policy tightening and inflation seem poised to overpower any incipient signs of slowdown. Until concrete disinflation takes root, the reality of higher yields for longer looks set to sink in.