How high can it go? Analyzing the 10-year yield's rapid rise

DEWITT, Mich. - Oct. 25, 2023 - PRLog -- Key takeaways:

• This past week, markets remained on edge as Treasury bond yields continued their march higher. The 10-year Treasury yield is getting particular attention as it nears 5%, a level last seen in 2007. The two-year yield, which tends to follow the path of the fed funds rate over time, also reached a high of the cycle at close to 5.15% as the Federal Reserve maintains the option of another interest rate hike ahead.
• The rapid move higher in government bond yields has increased volatility in both equities and bonds. The S&P 500 sold off by over 1.5% last week, while the Bloomberg U.S. Aggregate bond index was down over 2%. More broadly, higher yields can increase the cost of borrowing, put downward pressure on stock valuations, and weigh on bond price returns.

What is driving yields higher?

Overall, a resilient economy and higher fiscal deficits (and more supply coming to the market), coupled with lower demand and higher global interest rates, are helping to drive yields higher. We highlight three key factors that have contributed to the recent rise of 10-year bond yields:

1. A resilient economy — Clearly, the U.S. economy has defied calls for recession this year, maintaining an above-trend growth rate for the first three quarters of the year.

The stronger-than-expected growth puts some upward pressure on Treasury yields as well, as yields partly reflect the growth prospects of the economy over time. However, we would expect some potential economic cooling in the quarters ahead, particularly as the labor market perhaps softens and consumption cools, driven by lower savings rates and higher debt levels overall. This moderation may also alleviate the ongoing upward pressure on Treasury yields.

2. Supply/demand imbalances — Given the growing U.S. fiscal deficit, the Treasury Department has been increasing its auction sizes for U.S. Treasury bills and notes, adding more government bonds to the market. This year, for example, the total amount of Treasuries issued in auctions is expected to climb to over $3 trillion, higher than at any year over the past decade (excluding the 2020 pandemic surge). Forecasts call for this figure to increase next year.

3. Global central banks raising rates — Perhaps another reason for the rise of the 10-year yield has been the rise in the yields of other major economies. For example, Japanese yields have risen to the highest levels since 2012, making them once again attractive for domestic buyers. Historically, Japan has been the largest foreign holder of U.S. Treasuries, and the rise in its own government bond yields could crowd out some demand for U.S. government bonds.