How Much Longer Will U.S. Treasury Bonds Continue to Fall?

Recently, the relentless rise of U.S. Treasury yields has cast a shadow over global financial markets, sparking considerable concern.

On October 23, the yield on the 10-year U.S. Treasury bond, often regarded as the "anchor for global asset pricing," surged past the 5% mark, reaching its highest point since 2007.

An increase in bond yields translates to a decrease in prices, indicating intense selling pressure in the current U.S. Treasury market.

The decline in U.S. Treasury prices has resulted in a drag on global financial markets, with the S&P 500 experiencing five consecutive days of loss, hitting a new low since May.

On October 24, Asian markets exhibited general volatility, with major indices in Hong Kong, South Korea, and Japan all witnessing intraday declines.

The Five Key Factors

Since mid-July, the acceleration of U.S. Treasury yield increases has gained significant momentum.

Recent observations from Federal Reserve officials and strong U.S. economic data imply that interest rates may remain higher for a longer period than many had anticipated.

Huang Jiacheng, Managing Director and Head of Fixed Income for Asia Pacific at Invesco, summarized five key reasons for the rise in U.S. Treasury yields during a recent interview.

Advertisement

Firstly, the U.S. economy grew significantly faster than expected in the first half of this year. This adjustment has shifted market expectations regarding the economy and lowered estimates for unemployment, prompting a reassessment of the Federal Reserve's interest rate hike trajectory.

Secondly, while inflation in the U.S. has eased this year, it still exceeds the Fed's target, with core inflation remaining at relatively elevated levels. The recent surge in oil prices has also exerted upward pressure on overall inflation levels.

Recent data from the U.S. Department of Labor revealed that the Consumer Price Index (CPI) for September increased by 3.7% year-on-year and by 0.4% month-on-month, both surpassing expectations.

Thirdly, the hawkish signals from the Federal Reserve. This confidence in the economic outlook has influenced many individuals' judgments about the pace of interest rate hikes; earlier this year, many anticipated deflation, yet the lack of deflationary trends from then until now has been prompted by these hawkish signals.

Last week, Federal Reserve Chairman Jerome Powell delivered a final crucial speech before the November meeting at the New York Economic Club, indicating the Fed is likely to hold steady in the upcoming meeting. However, he also stressed the possibility of rate hikes if stronger economic growth signals emerge.

Powell noted that inflation remains too high, indicating that the road to combat inflation could be rocky and time-consuming, and affirmed the Fed's commitment to sustainably reduce inflation to 2%. Achieving this goal may require a period of below-trend economic growth and further weakening in the labor market.

Additionally, Cleveland Fed President Loretta Mester expressed last Friday that she believes the Fed may raise rates again this year, consistent with the central bank's September "dot plot" forecast.

Fourthly, from a supply-demand perspective, the market struggles to absorb the significant supply of U.S. Treasuries, leading to the need for yields to rise in order to enhance their attractiveness.

On the supply side, the U.S. government is expected to continue operating with high deficits, indicating that substantial public debt issuance is likely to persist. According to Treasury data, plans call for net issuance of $1.01 trillion and $852 billion in Treasury bonds in the third and fourth quarters, respectively. Concurrently, the Fed is also reducing its bond holdings through quantitative tightening, resulting in a cumulative reduction of $1.3 trillion since 2022, effectively increasing the supply of Treasuries in the market.

On the demand side, foreign investors have generally adopted a shedding approach; the total amount held has decreased by $121 billion since 2022.

As of the end of August, mainland China, the second-largest foreign holder of U.S. debt, had its holdings drop to $805.4 billion, marking a 14-year low. Japan, the largest holder, also cut its bonds by $30.4 billion in May, the largest monthly reduction since October of the previous year.

Lastly, the downgrading of the U.S. international credit rating. On August 1, rating agency Fitch downgraded the U.S.'s long-term foreign issuer default rating from "AAA" to "AA+". "Many funds that could have retained AA will now be liquidated or reduced."

Widespread Implications

The U.S. Treasury market is seen as the cornerstone of the global financial system, and the implications of soaring yields are sure to be far-reaching.

Higher Treasury yields and premiums are likely to weigh on investors' preferences for stocks and other risk assets by tightening financial conditions, alongside increased borrowing costs for both corporations and individuals.

According to data from S&P Global Market Intelligence, the global stock market recently hit its lowest level since April. The S&P 500 has now fallen about 7% from its peak this year, as the yield on U.S. government debt attracts investors away from the stock market. Meanwhile, mortgage rates have reached their highest levels in over 20 years, putting considerable pressure on the U.S. real estate market.

In the corporate bond space, the recent surge in Treasury yields has widened credit spreads once again, increasing financing costs for potential borrowers, particularly among junk bonds. An index measuring global high-yield bonds saw average yields soar to 9.26%, the highest level since November of last year, nearly double that of early 2022.

However, the spike in Treasury yields has concurrently accelerated demand for the dollar. Since mid-July, with rising Treasury yields, the dollar has appreciated about 7% against a basket of G10 currencies. The dollar index, which measures the dollar's strength against six major currencies, is recently nearing a 10-month high.

Short Sellers Retreat

Currently, major financial institutions like Bank of America, Morgan Stanley, and Goldman Sachs indicate that Treasury yields have likely "peaked."

Morgan Stanley posits that when the 10-year Treasury yield reaches 5%, it will represent "an excellent entry point."

Goldman Sachs anticipates that the 10-year yield could decline to between 4.2% and 4.3% in the short term.

Bank of America’s Chief Investment Strategist, Michael Hartnett, has declared that U.S. Treasuries will be among the best-performing assets in the first half of 2024.

In addition to large banks, notable market figures who previously had bearish positions on Treasuries are also beginning to "retreat."

On October 23, hedge fund mogul Bill Ackman, founder of Pershing Square Capital Management, announced he had closed his short position on long-term Treasuries.

Ackman believes there are too many global risks and that continuing to short the bond market at current yield levels is inadvisable. Furthermore, he contends that the pace of the U.S. economic slowdown is faster than recent data indicates.

Following Ackman's announcement, the 10-year Treasury yield significantly retreated, dropping more than 10 basis points from its daily high to around 4.88%.

"Bond King" Bill Gross tweeted on October 23 that he is purchasing short-term interest rate futures tied to the Secured Overnight Financing Rate (SOFR). He expects the yield spread between the two-year and ten-year Treasuries, as well as that between the two-year and five-year Treasuries, to turn positive by year's end.

Gross's purchasing of short-term rate futures is based on his expectation of an economic recession in the fourth quarter. He observed that turmoil among regional banks and rising auto loan delinquency rates indicate a significant slowdown in the U.S. economy.