The 10-year and 30-year yields moved 23–30 basis points higher to 4.2% and 4.34%, respectively, both a stone’s throw away from their 4.34% and 4.39% cycle highs. However, the real surprise came in the shape of the yield curve. Over the last several years, rising interest rates have been accompanied by a flattening yield curve. Whether the drivers that pushed yields up were higher inflation or greater-than-anticipated growth, the brunt of rising rates have been in the short end of the curve as markets recalibrated the potential for rate hikes and the Federal Reserve’s terminal rate. As we reach the end of this cycle, however, those incremental moves by the Fed are having less of an impact on short-end interest rates.
For the first time in nearly a year, the market is now refocusing on those performance drivers that have taken a backseat up until now. First, the Bank of Japan (BoJ) announced a change in its yield-curve control policy, which pushed the 10-year Japanese government bond yield to 0.65%, its highest level since January 2021. Second, on the supply side, the Treasury’s refunding announcement surprised the market, as the rising budget deficit—projected to be around USD 1.8tr in 2023 due in part to weaker capital gains tax revenue—proved to be much larger than expected. In fact, the USD 1tr in debt issuance expected this quarter will be the second highest on record, and likely start a trend that will cross over into 2024.
With the higher-than-anticipated supply, alongside the continued quantitative tightening by the Fed, fixed income investors are requiring additional compensation to lock up money for longer. The 10-year term premium—a measure of the compensation received by locking up money for 10 years versus simply buying a 1-year Treasury and rolling forward 10 times—spiked over the past week. Given that we are in the late stages of the rate-hiking cycle, we anticipate the term premium to remain negative, and it will be the fundamentals that will ultimately drive the level of interest rates.
While the Fitch downgrade of the US credit rating last week was also a surprise, it was a smaller driver compared with supply, the BoJ, and the hawkish repricing of the 2024 fed funds path, which has moved from 160bps of easing the first week of July to about 120bps today. This put the market pricing closer to the Fed’s guidance of 100bps in the June dot plot.
While the market will shift focus to the CPI number on Thursday, the 15% rise in WTI oil prices in July to USD 83/bbl (near the highest since November) and the 4.4% year-over-year increase in hourly wages (which beat consensus estimates) have caused inflation expectations to trend higher. The forward 10-year and current 30-year breakeven inflation rates are at the highest levels since May 2022 and March 2023, respectively.
While last week’s abrupt move in the 30-year nominal yield (nearly 30bps in three days) outweighed the rise in inflation expectations, at 1.87% the 30- year real yield now sits at its highest level since 2011, while the 5-year/30-year yield curve is now positive at 6.73bps. While we anticipated a steepening of the curve in 2H23, we believe most of the recent move is a knee-jerk reaction to the unanticipated supply hitting the market. The 2-year/10-year curve has steepened nearly 35bps in the past two weeks to –71bps, but given our “higher for longer” view on rates, we do not anticipate an upward sloping yield curve until 2024.
With the market digesting multiple technical bearish variables over the past week, we will once again shift to the data. We continue to anticipate slower growth in the second half of 2023, alongside lower 10-year yields by yearend to around 3.5%.
Main contributors: Solita Marcelli, Leslie Falconio
Original report: Fixed income: From behind the scenes to center stage , 7 August, 2023.