Will US Bond Yields Keep Soaring?

Analysts believe that, taking history as a mirror, the current level of U.S. Treasury yields is appropriate, but the U.S. government may come up with another "harebrained scheme" next month, and this risk could further push up U.S. Treasury yields...

Investors have been selling U.S. government bonds as the market is adjusting to the prospect of higher interest rates for a longer period.

The U.S. Treasury sell-off that began in early October is one of the worst collapses in bond market history, and last Friday, the 10-year U.S. Treasury yield touched 5% for the first time since 2007.

Christoph Schon, Senior Director of Applied Research at Qontigo, a market data and intelligence company, said that a 10-year Treasury yield level of 4.7%-5.1% seems appropriate relative to the current long-term inflation expectation of around 2.45%.

He explained that in the 1980s and 1990s, the 10-year U.S. Treasury yield was about twice the inflation expectation, that is, the 10-year breakeven inflation rate. At that time, investors expected real returns to match the expected inflation rate.

It was not until the dot-com bubble and the 2008 financial crisis that this changed. Amid long-term stock market fluctuations, U.S. Treasuries became an asset where investors could park cash.

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"Stock and bond prices began to move in opposite directions, complementing each other according to risk preferences," Schon said.

He added that consumer prices have soared in the past two years due to the pandemic and the Russia-Ukraine conflict, which means that stocks and bonds are correlated again, and both assets are sold off in the face of a significant rise in interest rates.

"Our view is that the current environment is more like the early years of this century, when Treasuries were an attractive alternative to stocks, not just a safe haven in turbulent times," Schon said. "History suggests that the yield investors expect should be between 1.9 and 2.1 times the inflation expectation. Therefore, the current 10-year breakeven inflation rate of 2.45% implies a corresponding nominal yield between 4.7% and 5.1%."

As for where key bond yields will go next, history also has an answer. Schon said that unless there is a significant upward revision in inflation expectations, the likelihood of the 10-year U.S. Treasury yield climbing above 5.5% is less than 1%.Federal Reserve Chairman Powell commented in New York last Thursday that policymakers will let the fluctuations in the bond market play out, and that rising yields help to tighten financial conditions. Currently, the CME FedWatch Tool shows that the market expects a 98% chance that the Federal Reserve will not raise interest rates at the meeting on November 1st, and a 24% chance of a 25 basis point increase in December.

However, other strategists have warned that yields could still rise. MRB Partners Global Strategist Phillip Colmar predicts that by 2024, yields could indeed surpass 5.5%. Adam Phillips, Managing Director of Portfolio Strategy at EP Wealth Advisors, warns that a potential government shutdown in November could be another factor driving yields higher.

Barclays strategists pointed out last Wednesday that the 10-year Treasury yield is still below the expected terminal rate of the Federal Reserve's current tightening cycle, which is inconsistent with the usual end of a tightening cycle.

In a report, Barclays strategists stated, "The obstacles to a (bond) rebound remain high. Despite data continuing to show the resilience of the economy, there is a widespread expectation that economic growth will slow significantly in the coming quarters. Repeated missteps raise the question of whether the market is overly confident in monetary policy being too tight. We believe that policy has hardly tightened, and the risk leans towards interest rates continuing to experience unexpected upside surprises."