Treasury Yields: The Long and Winding Road to 5%

July 13, 2023 Kathy Jones
Now that short-term Treasury yields have reached 5%, further upside is likely to be limited.

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.

It took a long time for two-year Treasury yields to climb back to pre-financial crisis levels

Chart shows the 2-year Treasury yield dating back to July 2006. The yield was 4.8% as of July 12, 2023, near the highest point it has been since before the great financial crisis.

Source: Bloomberg, daily data as of 7/12/2023

US Generic Govt 2-year yield (USGG2YR index). Past performance is no guarantee of future results.

Five takeaways on reaching 5%

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.

The yield curve inversion is steeper than it has been since the early 1980s

Chart shows the 2-year/10-year yield spread dating back to July 1978, with gray bars overlaid to show recessions. At negative 86 basis points as of July 12, 2023, the inversion is the steepest it has been since the early 1980s.

Source: Bloomberg, daily data as of 7/12/2023

Market Matrix US Sell 2 Year & Buy 10 Year Bond Yield Spread (USCY2Y10 index). The rates are comprised of Market Matrix U.S. Generic spread rates (USYC2Y10 index).  This spread is a calculated Bloomberg yield spread that replicate selling the current 2 year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100.

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.

Volatility is still elevated

Chart shows the MOVE index dating back to 2018. At 127 index points as of July 11, 2023, it is down from highs reached several months ago, but is still relatively high compared with its history.

Source: Bloomberg, daily data as of 7/11/2023

The Merrill Option Volatility Estimate (MOVE) index is a market-implied measure of bond market volatility. The MOVE index calculates the implied volatility of U.S. Treasury options using a weighted average of option prices on Treasury futures across multiple maturities (2, 5, 10, and 30 years).

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.

High-yield credit spreads are well below previous peaks hit during periods of market stress

Chart shows the average option-adjusted spread of the Bloomberg U.S. Corporate High-Yield Bond Index dating back to 2010. The OAS was at 3.97% as of July 7, 2023.

Source: Bloomberg, weekly data as of 7/7/2023

Bloomberg U.S. Corporate High-Yield Bond Index (LF98TRUU Index). Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. For illustrative purposes only. Past performance is no guarantee of future results.

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.

The interest rate differential between U.S. and other global bonds has widened

Chart shows the 52-week rolling correlation between the Bloomberg U.S. Aggregate bond index vs. the Bloomberg Global Aggregate ex-USD Index and the Bloomberg Emerging Markets USD Aggregate Bond Index dating back to January 2004. Correlation between both of the foreign bond indices and the U.S. Agg has increased in recent months.

Source: Bloomberg, weekly data as of 7/7/2023

Bloomberg Emerging Markets USD Aggregate Bond Index (EMUSTRUU index) and Bloomberg Global Aggregate ex-USD Index (LG38TRUU index). Correlation is a statistical measure of how two investments have historically moved in relation to each other and range from 1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of 1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated.

The yield difference between the two-year Treasury and other major country bonds

Chart shows the spread difference to a 2-year U.S. Treasury security of sovereign bonds with similar maturities issued by Japan, France, Germany, Britain, Italy and Canada.

Source: Bloomberg, weekly data as of 7/7/2023

U.S. Generic Govt 2-year (USGG2YR index), Generic Japan Govt 2-year (GTJPY2Y Govt index), Generic France Govt 2-year (GTFRF2Y Govt index), Generic German Govt 2-year (GTDEM2YR Govt index), Generic Britain 2-year (GTGBP2Y Govt index), Generic Italy 2-year (GTITL2Y Govt index), Generic Canada 2-year (GTCAD2Y Govt index).  Past performance is no guarantee of future results.

The yield difference between the 10-year Treasury and other major country bonds

Chart shows the spread difference to a 10-year U.S. Treasury security of sovereign bonds with similar maturities issued by Japan, France, Germany, Britain, Italy and Canada.

Source: Bloomberg, daily data as of 7/7/2023

U.S. Generic Govt 10-year (USGG10YR index), Generic Japan Govt 10-year (GTJPY10Y Govt index), Generic France Govt 10-year (GTFRF10Y Govt index), Generic German Govt 10-year (GTDEM10YR Govt index), Generic Britain 10-year (GTGBP10Y Govt index), Generic Italy 10-year (GTITL10Y Govt index), Generic Canada 10-year (GTCAD10Y Govt index).  Past performance is no guarantee of future results.

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.

Real Treasury yields are at their highest levels in years

Chart shows real Treasury yields dating back to 2008. As of July 12, 2023, the real 2-year yield was 292 basis points, the real 5-year yield was 197 basis points, the real 10-year yield was 168 basis points and the real 30-year yield was 176 basis points. In some cases this is the highest level in a decade.

Source: Bloomberg, daily data as of 7/12/2023

US Generic Govt TII 2 Yr (USGGT02Y index), US Generic Govt TII 5 Yr (USGGT5Y index), US Generic Govt TII 10 Yr (USGGT10Y index), US Generic Govt TII 30 Yr (USGGT30Y index). A basis point (bps) is one-hundredth of 1 percentage point, or 0.01%. Past performance is no guarantee of future results.

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.

Portfolio positioning in a higher-rate environment

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.

1 A basis point is one-hundredth of 1 percentage point, or 0.01%, so 25 basis points would be equal to 0.25%.

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