In mid-August, longer-dated U.S. Treasury yields broke higher to levels not seen in more than 10 years.
Interest rates are driven by performance of the economy, inflation expectations, and by the demand and supply dynamics of bonds.
In this paper, we analyze and dissect the interest rate environment along these three categories – in each case, the evidence suggests investors should anticipate a ‘higher for longer’ interest rate environment.
- Tight labor market conditions and wage growth have led to persistently high inflation, and rising energy prices will only serve to support this trend.
- The U.S. economy has shown growth, with a robust third-quarter GDP forecast of 4.9%.
- Actions by the Fed and U.S. Treasury provide an ongoing supply of U.S. Treasuries, while International demand for U.S. Treasuries is falling.
Factors Driving the Uptrend in Long Rates
Early August saw a selloff in U.S. Bonds. This aggressive selloff, which was targeted in the longer-end of the curve (10+ years duration), came around the Fitch downgrade of US government debt.
In addition, the Bank of Japan (“BOJ”) widened its target 10-year Japanese Government Bond (“JGB”) yield ban, lifting the ceiling from 0.50% to 1.00%. This has provided Japanese investors with fewer reasons to buy U.S. Treasuries – in fact, Japan has seen its allocation to U.S. Treasuries as a percent of their total government debt steadily decline over the past 10+ years. In reaction, investors outside of Japan have started to sell and/or increased their level of U.S. Treasury sales.
Apart from these outside forces, U.S. economic data has mostly remained consistent with expansion, rather than contraction. Regarding U.S. Treasuries, from a demand and supply standpoint, supply is on pace to overwhelm demand.
Economic Indicators Pointing Towards Growth
The Federal Reserve Bank of Atlanta’s ‘GDPNow’ forecast is estimating third quarter U.S. growth to be at 4.9% at time of publication. This is a large acceleration from the 2.0% and 2.1% in the first and second quarter respectively.
Despite the Purchasing Manager’s Index (“PMI”) surveys pointing to a contraction through the past year, after adjusting for inflation, ‘industrial production’ has been positive year-to-date in 2023. The July release was also much stronger-than-expected.
While certain segments of the U.S. housing market have ebbed and flowed, new home sales have remained quite strong, and will most likely see an uptick in durable goods as new home-owners aim to furnish their homes.
The latest U.S. employment report is healthy. The headlines met expectations but underlying the report is stronger job growth in the private sector, and in manufacturing. The softer ‘average hourly earnings’ were more than offset by an increase in ‘average weekly hours’. Average take home pay actually increased.
The U.S. economy has shown growth, with a robust third-quarter GDP forecast of 4.9%
Inflation Expectations and Labour Market Dynamics
Following the softer-than-expected July Consumer Price Index (“CPI”) report, U.S. July Producer Price Index (“PPI”) was stronger-than-expected (PPI leads CPI). Inflation from the business sector (PPI) should be passed onto the consumers, putting upward pressure on future CPI. In the August CPI report, a sizeable increase was found among the energy components, as ‘predicted’ by PPI, while the core components softened. Headline inflation moved higher both month-over-month and year-over-year. It is important to note that wages are a key component of core inflation.
Tightness in the labour market has been persistent. ‘Weekly Jobless Claims’ have averaged around 230,000, far below levels of 500,000 or higher during previous recessions. According to the Bureau of Labor Statistics (“BLS”), the U.S. ‘Prime Working Age Employment” is at a new post 2001 high, at 80.9%.
Rising wages have been a result of this. Wage growth has been ‘sticky’, hovering around 5% on an annual basis. This is partly a result of a shortage in the labour market, with employers still paying up to attract employees. Wages are a key component of core inflation and its strength has the ability to keep core inflation underpinned. Widespread strikes and subsequent settlements, think UPS and the ongoing United Auto Workers negotiations, are pointing to entrenched inflation expectations, and the resurgence of labor in collective bargaining. A ‘wage-price spiral’ could be underway, in which higher prices prompted employees to demand higher wages, which in turn morph into higher prices for the products or services they provide.
CPI may get another boost given the resurgence in energy prices. Crude (“WTI”), from its recent low in late June, is up 37%, as of September 19, 2023. U.S. rig counts are down, diminishing supply. China is still struggling to jump-start its economy, which could lead to an increase in pending demand. The Biden Administration has also been quite slow to replenish the Strategic Petroleum Reserve. Perhaps more importantly, OPEC, led by Saudi Arabia, has made it quite clear their preference is for higher oil prices.
The outlook for inflation points to a higher, if not steady, figure rather than a significant move down. The recent declines may prove to be just a pause in a longer uptrend.
Policy Factors Supporting Rising Yields
Although acting independently of one another, ‘Quantitative Tightening’ by the Fed and actions by the U.S. Treasury have put upward pressure on yields.
The Federal Reserve is on autopilot to shrink its balance sheet, that is, sell assets. The Fed’s balance sheet peaked in April 2022, at $8.9 trillion. After more than one year of ‘Quantitative Tightening’, the Fed’s balance sheet is now $700 billion lower. Treasury sales north of $400 billion since April 2022 have put downward pressure on prices and upward pressure on yields. Using a conservative Fed balance sheet target of $6.0 trillion, that will equate to sale of $1.4 trillion in Treasuries over the next 23 months.
After a resolution to the ‘Debt Ceiling’ was passed by Congress, borrowing by the Treasury, as anticipated, increased. Over $1 trillion in additional borrowing is presumed to take place over the next 12 months. The year-to-date budget deficit has already reached $1.3 trillion. Of the total level of Federal debt around $32 trillion, approximately $24.7 trillion is held directly by the public. After projecting for massive additional borrowing by the Treasury, the Congressional Budget Office (“CBO”) has estimated the debt outstanding held by the public to grow to $46.7 trillion by 2033 – this equates to an approximate 90% increase from current levels. This estimation also makes the assumption that there are no negative shocks and that Nominal Gross Domestic Product (“GDP”) growth remains robust. U.S. Federal debt will continue to climb and with high servicing costs, the increase in supply will be significant. This will place additional upward pressure on treasury yields all along the yield curve, and/or at least keep rates underpinned in the short-to-medium term.
The U.S. economy has shown growth, with a robust third-quarter GDP forecast of 4.9%
The breakout in long rates prior to August’s Jackson Hole has reduced the ‘inversion’ in the yield curve – ‘Bear steepening’, in which the whole yield curve shifts higher with long rates rising more than short rates.
In his Jackson Hole speech, Fed Chair Powell reiterated that the Fed’s fight against inflation is not done, and that softness in the labour market, that is a prerequisite for inflation to come down, has yet to show up. He also rejected the idea of lifting the inflation target from 2.0% to 3.0%. Advocates of a higher inflation target were hoping for a less vigilant Fed as a result of that. Clearly, Chair Powell is trying to correct that.
The market has largely misjudged Chairman Powell’s resolve to fight inflation. He has given little to no reason to doubt that the Fed will maintain their current mandate, that is, at a minimum, a ‘higher for longer’ mantra. Tarnished by his earlier ‘transitory’ stance, he must defend his legacy by crushing inflation. An economic slowdown, in his mind, would be ‘justified’ in order to meet his inflation target of 2%.
To potentially rectify the present mispricing between the Fed Funds and long-end of the curve, the Fed Funds future curve should remove the expectations for an interest rate cut in 2024, and longer duration yields should increase to properly price in a stickier, longer-term inflation outlook. Any expectation of an interest rate cut, at least in the foreseeable future, is misplaced.
The inversion of the yield curve was largely precipitated by consensus positioning revolving around the anticipation of an inevitable recession, falling inflation and more importantly, a pivot from the Fed pivot, meaning a cut to the level of interest rate cuts. The Fed funds future market is still pricing in 2 to 5 quarter point cuts throughout 2024. Historically, inversions have largely been driven by a fundamental shift in the demand and supply of capital, however, this inversion bucks the trend and is inconsistent with healthy economic data and persistent inflation.
Conclusion – The Path Forward for Interest Rates
Interest rates are driven by performance of the economy, inflation expectations and by demand and supply of bonds.
While some recent economic data may suggest a mitigation in the need for sustained higher rates, such as: the recent reduction in Core CPI, which has decreased to its lowest level since September 2021 (4.3%); a notable deterioration in consumer credit; and, a growing risk of global economic weakness, particularly in relation to Europe and China, we believe the Fed’s position will remain resolute.
The recent rise in energy prices and sticky wages will keep U.S. inflation underpinned. De-globalization and green energy will put secular upward pressure on inflation. The underlying U.S. economy, to the surprise of many, has been quite resilient to the speed and level of interest rate hikes. Many ‘hard data’ (as opposed to ‘soft data’ like PMI’s) are far enough away from recession levels. The U.S. economy, to the surprise of many, has been much less sensitive to interest rate increases; at least in the short-term.
While the markets zero in on changes in the Fed funds rate, ‘Quantitative Tightening’ is on autopilot, and it has its share of impact all along the yield curve, underpinning rates. With the exodus of $95 billion a month, the impact will inevitably be felt in asset markets.
Demand for Treasuries from the recession/rate cut camp has largely been satisfied. The U.S. Treasury 10-year yield at press time is 4.26%, after reaching 4.36%, the highest since November 2007, putting long Treasuries positions held by the ‘recessionistas’ under water. The 10-year yield remains on a strong, upward trajectory. At the same time, supply is still on the rise through new and additional Treasury Borrowing and Quantitative Tightening. The recent surge in bond yields in the long-end signals is further evidence that supply is beginning to overwhelm demand.
If inflation settles around 3.5%, add 0.5% for monetary policy to be restrictive (the Fed continues its fight on the way to its 2.0% target), add 2.0% term premium. The US 30-year Treasury bond yield could reach as high as 6.0%, not the current 4.41%.
The recent jump in long rates put more than 10-years of bond positions ‘under water’. The speed at which these ‘stale longs’ might be liquidated could determine the speed of any further rise in long rates. While the economy might be able to withstand a slow ‘grind higher’, a sudden surge could prove to be more damaging. Just when the calls of ‘soft landing’ reached a deafening level, the risk of a ‘hard landing’ actually has, if anything, gone up.
While a breakdown in yields is possible, factors like decreasing Core CPI and potential economic slowdowns globally pose risks to this trend, but the overall outlook suggests higher or steady inflation and yields.
The commentaries contained herein are provided as a general source of information based on information available as of September 20, 2023 and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication however, accuracy cannot be guaranteed. Market conditions may change and Caldwell Investment Management Ltd. accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained herein. Investors are expected to obtain professional investment advice.
Published on September 20, 2023