Federal Reserve Board Chair Jerome Powell delivered a news conference following a Federal Open Market Committee meeting at the Federal Reserve in Washington, D.C., on July 26, 2023, discussing the recent violent moves in the bond market. These swift and aggressive shifts have not only affected investors but have also reignited concerns about a possible recession, as well as apprehensions regarding housing, banks, and even the fiscal sustainability of the U.S. government.
The focal point of this turmoil is the 10-year Treasury yield, a significant figure in the world of finance. This yield, which indicates the borrowing costs for bond issuers, has steadily increased over the past few weeks and reached 4.8% on Tuesday, a level last witnessed just before the 2008 financial crisis.
The continuous rise in borrowing costs has surpassed the predictions of experts and left Wall Street searching for answers. While the Federal Reserve has been increasing its benchmark rate for the past 18 months, it didn’t impact longer-term Treasurys like the 10-year until recently, as investors believed rate cuts were imminent. However, this perception started to change in July when signs of unexpected economic strength emerged. The momentum gained further traction in recent weeks as Fed officials remained resolute in their decision to keep interest rates elevated. Some members of Wall Street speculate that part of this surge is due to technical reasons, such as selling from a country or large institutions. Others are focused on the escalating U.S. deficit and political dysfunction. There are also those who believe that the Federal Reserve intentionally caused the yield surge to slow down a potentially overheating U.S. economy.
“The bond market is indicating that this higher cost of funding will persist for a considerable time,” said Bob Michele, the global head of fixed income for JPMorgan Chase’s asset management division, during a Zoom interview. “It will remain at this level because that’s the target set by the Fed. The Fed wants to slow down the consumer.”
Investors are particularly fixated on the 10-year Treasury yield due to its significance in global finance. While shorter-duration Treasurys are directly influenced by Fed policy, the 10-year yield is driven by market forces and reflects growth and inflation expectations. It holds the most relevance for consumers, corporations, and governments, as it impacts trillions of dollars worth of home and auto loans, corporate and municipal bonds, commercial paper, and currencies.
“When the 10-year yield moves, it affects everything. It’s the most closely watched benchmark for rates,” explained Ben Emons, head of fixed income at NewEdge Wealth. “It has an impact on anything that involves financing for corporates or individuals.”
The recent fluctuations in the yield have put the stock market in a delicate position, as some of the anticipated correlations between asset classes have broken down. Stocks have experienced a sell-off since the yield started rising in July, erasing a significant portion of the year’s gains. Surprisingly, even U.S. Treasurys, considered a safe haven investment, have fared even worse. Longer-term bonds have experienced a 46% decline since their peak in March 2020, which is a steep drop for an investment perceived as one of the safest in the market.
“You have equities falling as if it’s a recession, rates climbing as if growth knows no bounds, gold selling off as if inflation is dead,” remarked Benjamin Dunn, former hedge fund chief risk officer and current head of consultancy Alpha Theory Advisors. “None of it makes sense.”
However, the impact on most Americans is yet to be fully felt, especially if rates continue to rise. The surge in long-term yields is aiding the Federal Reserve in its battle against inflation. By tightening financial conditions and lowering asset prices, demand is expected to decrease as more Americans cut back on spending or lose their jobs. Credit card borrowing has increased as consumers dip into their savings, and delinquencies are at their highest level since the start of the COVID-19 pandemic.
“People have to borrow at much higher rates than they would have a month ago, two months ago, six months ago,” said Lindsay Rosner, head of multi-sector investing at Goldman Sachs asset and wealth management. “Unfortunately, I do think there has to be some pain for the average American now.”
The impact will extend beyond consumers to affect employers, as they may scale back in response to the prevailing economic conditions. Companies that rely on high-yield debt issuance, including many retailers, will face significantly higher borrowing costs. Higher rates also squeeze the housing industry and increase the risk of default in commercial real estate.
“For anyone with debt coming due, this is a rate shock,” warned Peter Boockvar of Bleakley Financial Group. “For real estate professionals with loans coming due or businesses with floating-rate loans, this is a tough situation.”
The spike in yields also adds pressure to regional banks that hold bonds that have depreciated in value. This factor played a significant role in the failures of Silicon Valley Bank and First Republic. Although experts do not anticipate more bank collapses, the industry has been attempting to offload assets and has already reduced lending.
“Compared to March, we are now 100 basis points higher in yield. If banks haven’t resolved their issues since then, the problem has worsened because rates are even higher,” explained Rosner.
While the rise in the 10-year yield has temporarily stalled in recent trading sessions, many experts anticipate that it can climb higher since the factors believed to be driving the increase are still present. This raises concerns that the U.S. may face a debt crisis where higher rates and mounting deficits become deeply entrenched, a concern that is exacerbated by the possibility of a government shutdown next month.
“There are genuine concerns about whether we are operating at a debt-to-GDP level that is unsustainable,” Rosner added.
Since the commencement of rate hikes by the Federal Reserve last year, there have been two instances of financial turmoil: the September 2022 collapse of the U.K.’s government bonds and the March regional banking crisis in the United States. Another increase in the 10-year yield from its current level could raise the likelihood of another financial breakdown, making a recession much more probable, according to JPMorgan’s Michele.
“If the long-end yield surpasses 5%, this will be a genuine rate shock,” cautioned Michele. “At that point, we have to remain vigilant for any signs of weakness.”
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