Treasury Yields: The Long and Winding Road to 5%

Back in 2012 I wrote an article entitled, "The long and winding road back to 5% Treasury yields." At the time, I estimated that it would take at least another three years for yields to climb that high after the economic damage done by the great financial crisis of 2008. But a few years turned into a decade, as inflation and economic growth remained tame, and the global pandemic sent yields plunging back to near zero.

Now that yields have recovered from that lost decade and look poised to move even higher, it seems like a good time to re-assess the outlook for rates and portfolio positioning.

All indications are that the Federal Reserve is likely to raise its target range for the federal funds rate by another 25 basis points, to 5.25% to 5.50%, at its July 25-26 meeting and leave the door open to another increase in the fall. At a minimum, the Fed has signaled it plans to hold rates at these high levels at least through the end of the year—until it is confident that inflation is headed back to its 2% target.

For investors a "higher for longer" peak (or "terminal rate") for the federal funds rate in this cycle has several implications:

1. The downside potential in intermediate- to long-term yields for this year is likely higher than we previously expected. Intermediate- to long-term rates reflect expectations for the path of the fed funds rate plus a risk premium. Continued Fed tightening will likely pull rates higher across the yield curve. Rather than the 3.0% to 3.25% year-end target we had previously expected for 10-year Treasuries, a lower bound of about 3.5% is more likely and a re-test of the 2022 peak of 4.25%-4.35% is possible.

We expect the yield curve to remain inverted, but it is already near historically low levels last seen in the early 1980s. At a spread of about -100 basis points between two- and 10-year yields, more rate hikes are likelier to pull up yields across the curve than to deepen the inversion to new lows. Once a downturn in the economy begins, then 3% is still a reasonable downside target for 10-year yields—but that looks unlikely until 2024.

2. Volatility is likely to rise. In the bond market, volatility reflects uncertainty about the path of interest rates. With the Fed signaling the potential for more rate hikes and the market discounting the potential for rate cuts early next year, the tug-of-war between the market and the Fed will likely mean volatility stays elevated. It has retreated from the peak level reached in March but is well above the long-term average.

3. Credit spreads are more likely to rise than fall. So far in this cycle, credit spreads have stayed low, despite some volatility. The average spread of the Bloomberg U.S. Corporate High-Yield Bond Index is close to 4%, below its long-term average and well below previous peaks hit during periods of market stress or economic slowdowns. We expect spreads to rise, because further Fed tightening implies that economic growth will likely slow, resulting in more defaults from sub-investment-grade-rated issuers.

In general, we believe investment-grade corporate bond spreads are likely to remain relatively stable, but high yield bond spreads have the potential to widen, pulling down their prices.

4. International bonds are not likely to provide much diversification. The Fed isn't the only central bank hiking rates, but it has been moving them up rapidly. Consequently, the interest rate differential between U.S. bond yields and those in other major developed countries has widened in favor of holding U.S. bonds, and the correlation in returns has increased.

Emerging-market (EM) bonds may outperform due to higher yields, but EM economies are more exposed to a potential downturn in global growth and tend to be much more volatile than developed market bonds.

5. Real interest rates are likely to rise further. As the Federal Reserve holds or increases interest rates, bond yields adjusted for inflation expectations are likely to continue to move higher. Treasury real yields for all maturities are already at the highest level since 2008, reflecting the Fed's tightening moves to date.

With inflation in a downtrend, real rates should remain high or potentially move higher. That is the Fed's main tool for cooling off the economy. It also raises the risk of a recession and could strain liquidity in the financial system.

Now that short-term Treasury yields have reached 5%, further upside is likely to be limited. Although the economy has remained resilient in the face of the most rapid pace of rate increases since the late 1970s, inflation is cooling. Moreover, the Fed is likely near the end of its rate-hiking cycle, which would allow intermediate- to long-term yields to move lower over the next year. Ten-year Treasury yields have tended to peak within about six months of the peak in the fed funds rate in past cycles. If that pattern holds, then current yields may be near their highs.

For investors, current yields present an opportunity to extend the average duration in portfolios and lock in the highest yields in a decade for long-term cash flows. However, given the risk that the Fed overdoes its tightening and tips the economy into recession, higher-credit-quality bonds—like investment-grade corporate and municipal bonds—look more attractive than lower-rated bonds. In addition, Treasury Inflation Protected Securities (TIPS) provide an opportunity to lock in positive real yields and mitigate the impact of inflation.

Heightened volatility is likely to continue to be a feature of the higher-interest-rate environment. A laddered portfolio of high quality, diversified bonds that helps take some of the risk out of market timing can be a good way to manage through the rest of this interest-rate cycle.