Long-Term U.S. Treasury Yields Soared to Their Highest Levels Since 2007; What Are the Implications?

The recent surge in U.S. Treasury yields has taken many market participants by surprise, and it is difficult to point to any single fundamental factor that can fully account for the resulting turmoil.

Notwithstanding, some economists are attempting to identify the drivers behind this surge, and here are a few ideas that may help explain the recent rise in U.S. Treasury yields:

1. From the perspective of model disassembly, the upswing in term premium- which represents the additional compensation investors require for allocating funds toward long-term bonds and bearing the risks of interest rate fluctuations- has been the primary factor driving up recent long-term Treasury yields: This differs from the previous two-year period, where the rise in long-term Treasury yields stemmed mainly from an upward revision of expectations for the Fed's rate hikes driving up short-term yields, while term premiums remained comparatively low.

With the market anticipating an uptick in the midpoint of the inflation trajectory and heightened volatility, along with economic and monetary policy uncertainty, investors are requiring greater compensation for the risks associated with locking capital into long-term bonds, which led to an increase in the bond term premium. According to the New York Fed's ACM model, the 10-year U.S. bond term premium has recently turned positive, marking the first time since June 2021.

2. Fed rate hike is heating up due to optimistic expectations of U.S. economic growth: Differing from prior consensus, recent strong GDP and September nonfarm payroll data have highlighted the resilience of the U.S. economy despite concerns that cumulative Fed rate hikes would cause an economic slowdown. The CME FedWatch Tool indicates that traders are anticipating a 27.1% and 42.4% likelihood of rate hikes in November and December, respectively - significantly higher than the prior probabilities of 18.3% and 35.2% from just one week earlier. The higher probability of the Fed hiking rates has served to push yields even higher, thereby exacerbating the ongoing bond market rout.

3. Imbalance between supply and demand for treasury bonds: Barclays' research indicates that concerns over rising government debt issuance have been amplified due to large federal government deficits. Meanwhile, it is unlikely that the Fed will ease its quantitative tightening (QT) program or restart QE to support the bond market from a demand perspective. Additionally, well-heeled Treasury investors are gradually exiting the market, with reduced net purchases by overseas central banks such as China and Japan, as well as decreased demand from U.S. investment managers and banks.

4. Neutral rates may have risen: Powell mused in September that the neutral rate might have risen, at least temporarily, given the economy's remarkable resilience in the face of the Fed's aggressive rate hikes. While a time lag in monetary policy could contribute to the current robust economy, if neutral rates do increase, the Fed may have reasons to maintain higher interest rates for longer, justifying the recent surge in yields.

1. Dashing Hopes of a Soft Landing: WSJ's Nick Timiraos, known as the “Fed whisperer” warns that a surge in borrowing costs could lead to weaker investment, hiring, and economic activity, significantly weighing on economic growth, and potentially weakening the case for further rate hikes by the Fed this year.

2. Depressing Equity and Commodity Prices, Increasing the Risk of a Financial Market Collapse: As a global asset pricing benchmark, rising 10-year U.S. bond yields could exert pressure on the valuations of equities and other asset classes, including commodities such as gold, silver, and copper. Since its peak in August, the S&P 500 index has dropped by nearly 6%.Spot gold has sustained its downtrend and dipped near the $1,820-1830 per ounce threshold, hitting a seven-month low.