About the author: Gregory Daco is the chief economist at EY and former chief U.S. economist at Oxford Economics. Views expressed in this article are those of the author and don’t necessarily represent the views of Ernst & Young LLP or other members of the global EY organization.
Last week, we witnessed something that very few would have predicted just a few months ago: The yield on 10-year Treasuries surpassed the symbolic threshold of 5%. It was the first such instance since 2007, and it’s not a blip on the radar. Yields have risen 110-120 basis points since mid-July.
Inflation expectations are the usual suspect when bond yields surge like this, but surprisingly, that’s not the case this time. What we’re seeing is largely a reflection of escalating real interest rates.
Yet, these higher real interest rates also don’t reflect expectations for faster growth. The yield curve disinversion suggests investors aren’t holding their breath for further monetary policy tightening from the Federal Reserve. The question on everyone’s mind is, what’s really propelling these soaring yields?
A few plausible theories have emerged.
One is a newfound faith among investors that the Federal Reserve, in tandem with other central banks, is resolute in maintaining its current restrictive monetary policy stance for the foreseeable future.
Another is the underlying sentiment that long-term bond yields reflect anticipation of a higher inflation-adjusted neutral interest rate.
Third, there is a growing inclination among investors to demand greater compensation for buying into government debt, particularly when the looming cloud of federal government deficits hangs heavy. The Congressional Budget Office forecasts average $1.5 trillion to $2 trillion yearly for the coming decade.
A final possibility is that demand for bonds has become unpredictable as the era of the Fed being the pivotal buyer of Treasuries has been overshadowed by quantitative tightening. That’s happening while there’s a waning hunger for Treasury securities among commercial banks, hedge funds, pension funds, and insurance companies.
Given this backdrop, we are now staring at a future where long-term interest rates could potentially climb further or, at least, plateau at these elevated levels until the Fed pivots.
As affirmed by Fed Chair Jerome Powell and his team, tight financial conditions imply that the market is inherently sharing some of the Fed’s monetary policy tightening burden, which in turn reduces the urgency for additional rate hikes. However, the swift tightening of financial conditions also amplifies the likelihood of a fissure materializing in the economic outlook.
The linchpin for rates, moving ahead, will be tethered to the Fed’s responsiveness to the dual challenges of financial tightening and an impending economic deceleration.
Silence from policy makers is no longer golden. It has become a tacit form of forward guidance. If the endgame for Fed policy makers is to regain control of long-term rates and truly achieve a soft landing of the economy, the playbook needs a revision.
As I’ve maintained, navigating solely with the rearview mirror in an erratic economic, financial, and geopolitical climate is perilous. It’s imperative for policy makers to recalibrate, making their policy framework more prospective, especially when we’re transiting through a phase marked by dwindling economic vigor, recurrent supply hitches, and where inflation is no longer likely to be the No. 1 concern.
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