The other consideration is the Fed, which wants longer-term rates to remain restrictive to limit demand and depress inflation; it has the tools to bring markets to heel if it decides to use them. As Fed Chair Jerome Powell put it at his press conference on Nov. 2, the central bank is not just narrowly focused on the policy rate but also on bonds at all maturities.
We’ll want to get the policy rate to a level where the real interest rate is positive. We’ll want to do that. I do not think of it as the single and only touchstone though. I think you put some weight on that, you also put some weight on rates across the curve. Very few people borrow at the short end, at the federal funds rate for example ...
Powell didn’t explicitly say what he considers to be appropriate longer-term yields. But suffice it to say, his comments suggest he may not look approvingly on any significant rally in longer-term securities, given his stated objectives. If he comes to that conclusion, he can use future press conferences to jawbone yields back into line. And if it comes to it, he could accelerate the pace of so-called quantitative tightening by actively selling Treasuries from the Fed’s portfolio instead of simply letting them mature.
What’s the Bear Case?
These are the scenarios that are easiest to imagine. But importantly, neither one of them is terrible.
You have to get creatively gloomy to envision a future in which long-term bond yields go much higher from here, which is not to say that it’s impossible. You have to believe, for instance, that inflation expectations have become truly unanchored and that the US is heading for a wage-price spiral — that inflation has infected the national mindset and workers will start demanding raises, which employers will reluctantly deliver by raising prices. Not only that, but you have to assume that the Fed lacks the spine or tools to address the problem.
That’s not my assumption, but it’s a defensible argument. In the absence of such thinking, the risk-reward teeter-totter that investors care so much about has started to look relatively decent at current longer-term Treasury yields. Given the carnage that the bond market has just been through and the various perils facing other asset classes ahead of a possible recession, traders may be happy just to invest in an asset that they can reasonably predict won’t lead to any more losses.
Jonathan Levin has worked as a Bloomberg journalist in Latin America and the U.S., covering finance, markets and M&A. Most recently, he has served as the company's Miami bureau chief. He is a CFA charterholder.