In the 1990s, Democratic political adviser James Carville said: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
Not that long ago we lived in a world of free money. The Bank of Canada overnight rate and the Federal Reserve’s benchmark rate were near zero, while European and Asian central banks had negative rates following the financial crisis and then the pandemic.
In early October, markets were upended when 30-year US Treasury rates moved above 5% for the first time since 2007. Yields surged further following an unexpectedly significant uptick in US payrolls but have since moderated as investors shift to more conservative assets amid the escalation of conflict in the Middle East.
Why do bond yields keep rising?
Fiscal deficits have been rising in the US. For the fiscal year 2023, which concluded on September 30, the estimated deficit reached $2 trillion. Rising inflation has led to increased federal spending on Social Security and interest payments. Notably, net interest has become the fastest-growing category of federal government spending. After layering in additional spending approved last year by Congress, we will see federal expenditures increase further.
During the summer, Fitch downgraded the US federal debt rating from AAA to AA+ on August 1, citing concerns about mounting national debt and the perceived lack of political will in Washington to address the budget deficit. On August 1, the yield on the 10-year bond was 4.05%; it has now risen to nearly 4.80%.
Quantitative tightening. The Federal Reserve initiated its quantitative tightening (QT) program on June 1, 2022. From that date through the week of October 4, the Fed’s holdings of Treasuries has declined by $841 billion. The Fed is on pace to continue to reduce its holdings by $60 billion per month.
‘Higher for longer’ short-term interest rates. Federal Reserve Chair Jerome Powell exacerbated the spike in bond yields when he reiterated at his September 20 press conference that the Federal Open Market Committee (FOMC) intends to maintain the elevated federal funds rate for an extended period.
Bond buying by large investors. Treasuries have returned to the 4-5% range that prevailed before the financial crisis. Data from the US Treasury International Capital System indicates that major treasury bond investors have been adding to their portfolios over the past year. Japan, China and central banks remain large holders of treasuries.
US banks have reduced their holdings of treasuries and agencies (including mortgage-backed securities) by roughly $550 billion over the past year, but this appears to stem from a decision not to reinvest when Treasuries mature, rather than from actively selling off their portfolios.
For US banks, Treasuries have the benefit of being a risk-free asset. Unrealized gains and losses from Treasuries are recorded as an accounting entry under Accumulated Other Comprehensive Income (AOCI). A recent study by the Federal Reserve of Kansas examined the implications of unrealized losses for banks. The authors note that by the end of 2022, unrealized losses across all securities amounted to approximately 30 percent of the aggregate Tier 1 bank capital.
Securities classified as available for sale (AFS) with unrealized losses will directly reduce regulatory capital, while securities held to maturity (HTM) do not face any unrealized losses or gains. The study also notes that the proportion of securities held as HTM has increased significantly. Specifically, banks that are unable to opt out of reporting AOCI in regulatory capital – primarily larger banks – now hold more than 60 percent of their total securities as HTM.
The banking system cannot afford to crystallize these losses, and banks are unlikely to invest in longer-duration treasuries if they are concerned about rising interest rates.
The crucial question remains: how much of a backup in bond yields is necessary to attract demand from investors? US inflation is continuing to moderate, and it is likely that the Fed is done raising the federal funds rate. Given recent comments from Fed officials suggesting that the jump in rates may have mitigated the need for additional measures, it strengthens the case that we are through the rate tightening part of the cycle. We expect that US treasuries will stabilize between 4.5% and 5.0% from now into next year.
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