Interest rates on mortgages, credit cards and business loans have risen in recent months, even as the Federal Reserve left its key rate unchanged since July. The rapid rise has stunned investors and put policymakers in a dilemma.
The focus has been on the 10-year US Treasury yield, which underpins many other borrowing costs. The 10-year yield has risen a full percentage point in less than three months, briefly rising above 5 percent for the first time since 2007.
This sharp and unusually large increase, along with others, has sent shock waves through financial markets, leaving investors puzzled as to why rates remained so high for so long “before things broke down in a meaningful way.” How can it live at a high level, said US Prime Minister Subhadra Rajappa. Rates strategy at Societe Generale.
So what is going on?
Strong growth and stubborn inflation
Initially, when the Fed first began fighting inflation, it was short-term market rates – such as the yields on two-year notes – that rose rapidly. Those increases closely followed the Fed’s hike in the overnight lending rate, which took the country from zero to above 5 percent in about 18 months.
Longer-term rates, such as 10- and 30-year Treasury yields, moved lower because they are influenced by factors that have more to do with the long-term outlook for the economy.
One of the most surprising results of the Fed’s rate-hiking campaign, which aims to rein in inflation by slowing economic growth, has been the economy’s resilience. While shorter-dated rates are mostly tied to what’s happening in the economy right now, longer-dated rates take more into account perceptions of how the economy is likely to perform in the future, and they are changing.
From June to August, changes in 10-year yields mirror Citigroup’s Economic Surprise Index, which measures how much forecasts differ from the actual numbers as economic data comes out. That index has recently been showing that economic data has been consistently stronger than expected, and as the growth outlook has improved, long-term, market-based interest rates like the 10-year yield have risen.
A ‘higher for the longer term’ rate path
The better-than-expected jobs and consumer spending data are welcome news for the economy, but it complicates the Fed’s role in curbing inflation. So far, growth has stagnated due to low inflation.
But the economy’s resilience also means price increases have not slowed as quickly as the Fed — or investors — had hoped. Getting inflation fully under control may require keeping interest rates “higher for a longer time,” which has become a Wall Street mantra recently.
According to CME FedWatch, at the end of June, investors gave about a 66 percent chance that the Fed’s policy rate would end next year at least 1.25 percentage points below where it is now. This probability has since fallen to about 10 percent. The growing sense that rates won’t be coming low anytime soon has helped push 10-year Treasury yields higher.
Deficit, demand and the “term premium”
Generally, investors demand more – that is, a higher yield – for government lending for longer periods of time, to account for the risk of what might happen if their money is tied up. In theory, this extra return is called the “term premium.”
In fact, the term premium has become a kind of slang for the part of the yield that is left after the more easily measurable parts like growth and inflation.
Although the term premium is hard to measure, the general consensus is that it is increasing for a few reasons – and that is also increasing overall yields.
Large and growing federal budget deficits mean that the government needs to borrow more to finance its spending. However, it can be a challenge to find lenders who want to avoid the volatility of the bond market. As bond yields rise, prices fall. The value of the most recently issued 10-year Treasury note has already fallen about 10 percent since investors bought it in mid-August.
“Until it becomes clear that the Fed will raise interest rates, some investors will remain less inclined to buy,” said Sophia Drosos, economist and strategist at Point72.
Some of the largest foreign holders of Treasuries have already begun to step back. For the six months through August, China, the second-largest foreign lender to the United States, sold more than $45 billion of its Treasury holdings, According to official figures,
And the Fed, which owns large amounts of US government debt, which it bought to support markets during the turmoil, has begun shrinking the size of its balance sheet, reducing demand for Treasuries. Because the government needs to borrow even more.
As a result, the Treasury Department needs to provide more incentives to lenders, and that means higher interest rates.
What is the effect?
Its impact goes beyond the bond market. The rise in yields is hitting companies, home buyers and others — and investors are worried those borrowers could be squeezed.
Investors are analyzing earnings reports for the latest information on how companies are coping with higher interest rates. Goldman Sachs analysts noted earlier in the week that investors have focused on companies that are better prepared to weather any storms that may come, and are avoiding companies that are vulnerable to rising borrowing costs. are the “most vulnerable”.
The increase in rates is affecting the shares. As Treasury yields rose again on Tuesday, the S&P 500 fell 1.4 percent. The index has fallen about 9 percent since its peak in late July, which has coincided with a rise in yields.
