Who knew that the subject of U.S. Treasury bond yields could inspire such passion? When, in late June, I argued that they were likely to move considerably higher than the then-prevailing 3.75%, I attracted some vehement pushback. In a publication titled “Don’t Be a Dud,” analysts at Morgan Stanley insisted that the 10-year bond would experience a summer price rally, and that the yield would ultimately settle into a longer-term range of 2% to 3%.
I’m sticking with my prediction. What’s more, I strongly suspect that the bond bull market that began in the early 1980s is over.
My forecast broke the 10-year Treasury yield down into three constituent estimates. First, there’s r*, the “neutral” short-term interest rate that the Federal Reserve would set if it wanted to neither hinder nor stimulate growth. I put this at 1%. Then, there’s the average long-term inflation rate: 2.5%. Finally, I estimated the term premium, the added yield that investors will require to compensate for the risks of longer-term lending: 1%. From there, the arithmetic was simple: 1% + 2.5% + 1% = a target yield of 4.5%.
The Morgan Stanley analysts, by contrast, drew from the experience of the past decade to forecast that r*, inflation and the term premium would all be lower, resulting in a lower overall yield.
Since then, the 10-year yield has risen significantly, to about 4.3%. But I’m not taking a victory lap. My evaluation focused on longer-term secular trends, while the past month’s increase has a lot to do with cyclical developments such as a stronger-than-expected economy. I certainly didn’t anticipate that yields would immediately shoot up.
That said, secular elements are also evident. First, the economy’s strength amid much higher interest rates suggests that the neutral rate is higher than previously believed. This is starting to seep into Fed officials’ forecasts: In the June Summary of Economic Projections, the central tendency for the long-term federal funds rate moved up slightly. I expect officials to keep revising their estimates of r* upwards, though this probably won’t be reflected in estimates based on econometric models, which are slow moving and somewhat skewed by pandemic-period data.
Second, the U.S. government’s fiscal health keeps deteriorating: Last month, the Congressional Budget Office raised its estimate of this year’s federal budget deficit to $1.7 trillion from $1.5 trillion, and no improvement is likely anytime soon given the political deadlock in Washington. The outlook will probably deteriorate further as higher interest rates drive up debt service costs and retiring baby boomers push up Medicare and Social Security expenditures. Larger deficits push up r*, and add to the bond term premium by increasing the risk of long-term lending to the U.S. government.
The supply of government debt will be even greater than the deficit alone suggests. For one, the Treasury must borrow more to rebuild its cash balance at the Fed, after depleting it to get through the latest debt ceiling standoff. Also, debt must be issued to replace the Fed’s holdings, which are declining at an annual rate of $900 billion as part of the central bank’s quantitative tightening program—and will probably keep doing so for about two more years, even if the Fed reverses course on interest rates.
The bond term premium is the hardest part to forecast. Prior to the 2008 financial crisis, it averaged about 100 basis points. Since then, it has been around zero, in large part because there was little risk: Bonds were viewed as a good hedge against recession, and against the danger that the Fed’s monetary policy would become ineffective as interest rates got pinned to the zero lower bound. Now, chronically higher inflation is a much greater threat—one that might push the term premium back up to its pre-2008 level.
I don’t pretend to know how bond yields will move in the near future. Growth, employment and inflation will be the main drivers. But for the longer term, the steady economic expansion that followed the 2008 financial crisis is no longer relevant. The paradigm has shifted, and higher yields are back.
Bill Dudley, a Bloomberg Opinion columnist and senior advisor to Bloomberg Economics, is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs. He has been a nonexecutive director at Swiss bank UBS since 2019.
This article was provided by Bloomberg News.