Last week’s sharp moves in the US government bond market have people wondering about the implications not only for the outlook for other financial assets, including stocks, but also for the economy and policy. Here are my main takeaways and their consequences:
The volatility last week differed from that of 2022 and earlier this year because it was driven not by the policy-sensitive short end of the yield curve (such as the two-year Treasury) but by the longer-dated bonds. The yield on the 10-year note surged from 3.92% to 4.19%, retracing to 4.03% on Friday, while the yield on the 30-year bond rose from 4.03% to 4.20%, hitting a weekly high of 4.31%. This shift in drivers suggests a stronger convergence within markets on the Federal Reserve’s likely interest-rate path in the immediate future along with a broader range of factors influencing the long-term maturities.
The wider set of factors includes four domestic ones and a more uncertain international overlay.
Two dominant domestic factors are likely to have more lasting effects: the market’s adjustment to the prospects of significantly higher debt sales by the US government, especially in the midst of the shift by the Fed from quantitative easing (QE) to quantitative tightening (QT); and a growing understanding that current inflation dynamics will translate into higher interest rates for longer than markets had anticipated. Both these factors are likely to continue to contribute to volatility going forward.
The other two domestic factors are likely to be of less significance. This is especially the case for the downgrade of US sovereign debt by Fitch Ratings, whose importance has been dismissed by many economists and market participants. As to the economy’s growth outlook, the fourth factor, most forecasts already reflect the greater likelihood of the US avoiding a recession this year absent another policy mistake.
The international overlay is marked by considerable uncertainties surrounding the spillovers from the Bank of Japan’s gradual exit from its yield curve control policy (YCC). This process has already started to show signs that are familiar to those who have observed inevitable exits from fixed-exchange-rate pegs over time, often leading to repeated market tests of the authorities’ ability to manage an orderly withdrawal.
When combined, these factors point to three implications for the current Treasury market volatility: It is likely to diminish but not disappear; it is expected to result in range-bound yields overall unless the Bank of Japan fumbles in its YCC exit or the Fed tightens policy too much; and, with this important central bank qualification, it can be handled with relative ease by the economy and most segments of the financial markets provided they are not excessively levered.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of “The Only Game in Town.”