The 10-year Treasury yield climbed to a new 16-year high on Thursday as Federal Reserve chair Jerome Powell spoke at the Economic Club of New York. Powell said more tightening could be warranted if the recent run of strong economic data continues, but also noted that "financial conditions have tightened significantly" with the rise of long-term bond yields.
Powell committed to "proceeding carefully," signaling no rush to hike again. In the discussion that followed his opening remarks, Powell discussed the unexpected degree of economic strength. "It may just be that rates haven't been high enough for long enough."
Powell also discussed the new normal for interest rates following a period of ultra-low rates in the wake of the 2008 financial crisis. Asking himself whether rates would normalize between 4% and 5%, Powell said he guessed they might wind up somewhere in the middle — between the old normal and the ultra-low era.
Powell On 10-Year Treasury Yield
Why has the 10-year Treasury yield surged? Powell offered this: "It's not apparently about expectations about higher inflation." He also ruled out expectations of shorter-term Fed policy moves. "It's really happening in term premiums," he said, meaning the compensation investors demand for holding bonds for a longer time.
Powell also attributed the rise to "a heightened focus on fiscal deficits," adding that "QT (quantitative tightening, or reducing the Fed's balance sheet) could be a part of it."
Current debt levels aren't a concern, but the fiscal trajectory is, he said. "We'll have to get off that path sooner or later."
As Powell spoke, the 10-year Treasury yield hit 4.99% and remained there late Thursday afternoon. The S&P 500 initially wavered near the flat line, then turned solidly lower, sliding 0.9% after Wednesday's 1.3% drubbing.
Some of Powell's colleagues have said that the rising 10-year Treasury yield, which is a key input for auto loans and 30-year mortgages, as well as for growth stock valuations, is doing the Fed's work for it. Powell acknowledged that the higher 10-year yield could "at the margin" mean less need for rate hikes.
As of Thursday, markets see 0% odds of a quarter-point rate hike on Nov. 1, but those odds rise to 29% for the Dec. 13 policy update and 39% for Jan. 31.
10-Year Treasury Yield Supply Risks
Lately, worries about an oversupply of Treasuries have gotten worse. The breakout of war between Israel and Hamas adds to that risk, particularly if that war spreads. President Joe Biden plans to ask Congress for $100 billion in emergency funds in coming days to support Israel, Ukraine and Taiwan, as well as to bolster U.S. border security.
The running spectacle of House Republicans being unable to settle on a new Speaker also has implications for Treasury supply. Kevin McCarthy was demoted after eight Republicans withdrew their support following his deal to keep the government open. But the GOP doesn't have the votes to insist on stiff budget cuts.
Federal Reserve Balance Sheet
The batch of strong economic data highlights another risk — that the Federal Reserve will keep unloading the bonds it bought early in the pandemic to boost financial market liquidity. The Fed is letting up to $95 billion in Treasury bonds and mortgage securities run off its balance sheet each month.
The 10-year Treasury yield's latest upsurge began a week ago, when the core consumer price index matched expectations for a 0.3% monthly rise, but services prices came in unexpectedly hot. Then came the retail sales report, on Tuesday this week for September, which showed a 0.7% monthly rise that more than doubled forecasts even as prior data was revised higher. New claims for jobless benefits through the week of Oct. 14 fell 13,000 to 198,000, the lowest since mid-January.
Until the economy clearly softens, the Fed is unlikely to say much about its plans for eventually slowing and halting its balance-sheet tightening. However, one dovish member, Philadelphia Fed President Patrick Harker, told The Wall Street Journal this week that he's ready to start that conversation.
U.S. Treasury Borrowing
The Fed supply is exacerbating U.S. borrowing needs. On July 31, the U.S. Treasury surprised Wall Street by announcing its plan to issue $1 trillion in debt via public markets in the third quarter. The borrowing estimate was $274 billion higher than announced in May.
At the same time, foreign demand for U.S. Treasuries is revealing some holes. Wednesday's update of cross-border financial flows will only "add to fears" that China and Japan will be a no-show in financing U.S. fiscal deficits, wrote Deutsche Bank macro strategist Alan Ruskin. He noted that China sold $15 billion in U.S. Treasury notes and bonds and, unlike in past months, didn't offset those sales with purchases of other U.S. government agency securities.
Treasury Break-Even Inflation Rate
A look under the hood of the 10-year Treasury yield confirms that markets are much more worried about supply than the inflation outlook. Before Aug. 1, the 10-year Treasury yield had only made brief forays above 4%. But since then, the 10-year Treasury yield has vaulted 99 basis points, yet the inflation outlook has barely changed.
The inflation-compensation portion of the 10-year Treasury yield is known as the 10-year break-even inflation rate. This is derived by subtracting the 10-year TIPS (or Treasury Inflation-Protected Securities) rate from the 10-year Treasury yield. Since July 25, a day before Chair Powell revealed that Fed staff no longer expected a recession, the 10-year break-even inflation rate has risen modestly to 2.49% from 2.39%.
Meanwhile, the 10-year TIPS rate, which factors out inflation expectations, has jumped to 2.50% from 1.53%.
Interest-Rate Shock Coming?
The big question is how hard higher long-term interest rates will hit the economy and how fast it will happen. Already, applications for mortgages to buy a home have tumbled to the lowest level since 1995 as the average 30-year mortgage hit 7.7%, the Mortgage Bankers Association reported on Wednesday.
The interest-rate shock is also hitting just as payments on federal student loans are restarting after a three-and-a-half-year moratorium. So far in October, mortgage payments are running at a $75-billion annual rate above the year-ago pace.
