Are long-term US Treasury yields reaching the cycle peak?

Seven-to-ten-year US Treasury yields reached above 4% by the fourth quarter of last year, hitting multi-decade highs following a series of interest rate hikes since March 2022. Seven-to-ten US Treasury yields are the foundation of the global financial system impacting all risky assets. Hence a key question for investors: Have long-term Treasury yields peaked or are they close to peaking?

Chart 1 shows that longer-term Treasury yields are highly correlated with inflation, and as inflation has peaked, the indication is that longer-term Treasury yields could be approaching their current cycle peak. In this research piece, we analyse various drivers of long Treasury yields - inflation expectation, short-term policy interest rate, and term premium - to answer this critical investment question.

The Federal Funds Rate - the interest rate at which banks lend and borrow reserves from each other overnight, thus impacting borrowing costs for individuals and businesses in economic activities - is a key tool in the implementation of monetary policy by the Federal Reserve Bank. It has been utilised very effectively by the Fed to maintain financial and economic stability since Paul Volcker’s Fed in the 1980s, having controlled the high inflation and risks to economic performance. Playing a vital part in the financial market, bond yields are influenced by the fed funds rate: e.g., when the target Fed funds rate is raised, other fixed income investments may become less appealing as investors would require a higher rate of returns, which may push up the bond yields as a result.

So, the most recent surge in Treasury yields could be well explained by the rate hikes since March 2022, by the hawkish Federal Reserve, to control the sticky inflation during the post-Covid economic activity recovery. The rate increases of four and a quarter of a percentage point in 2022 (the upper limit rose from 0.25% through 4.5%), within 10 months, was one of the steepest rate hikes – mirrored by the steep surge in bond yields.

Looking forward, what could we expect about the future path of the Fed funds rate? A lot depends on the future of inflation!

First, if inflation is expected to be high in the future, investors may require a higher yield to compensate for the expected loss in purchasing power due to inflation, as conventional bonds pay off cash flows by a fixed coupon rate. Second, inflation expectation can change the shape of the yield curve, e.g., decreasing inflation expectations may result in the yield curve flattening, or sometimes inverted, as was quite noticeable recently.

By financial market practice, observations on yield spread between nominal and inflation-linked bonds with a similar maturity can be employed as a measure to gauge the market’s expectations for inflation, providing insight into inflation anticipation by bond investors. As illustrated in Chart 2, the US breakeven inflation rates rose significantly after the Covid outbreak, as the market expected the post-Covid bottlenecks in global supply chains and surging commodity prices to boost inflation. And the market reacted to the Russia-Ukraine conflict in a similar manner, with inflation expectations skyrocketing to a new high, led by the short-term. Reassuringly, breakeven inflations have decreased notably from the peak in March & April 2022, when the aggressive Fed initiated rate hikes to rein in the persistent inflations (not deemed as transitory as it once was), suggesting investors could finally see the light of a ‘normalizing inflation’ – approaching the target of 2% - at the end of the tunnel. In the meantime, with this diminishing inflation expectation, real yields were likely the main driver of the higher nominal bond yields since April. Another point worth noting is the short-term inflation breakevens have stayed above longer ones in recent two years, when inflation spiked up at an outstanding pace, unlike before the end of 2020.

Looking beyond the financial market, consumers’ expectations on price increases have contracted as well, as depicted in Chart 3, although the year ahead inflation expectations remain remarkably higher than in 5 years ahead, unlike the convergence among all tenors predicted by investors of the bond market. 

Given this expected path of inflation, what may lie ahead for inflation control by the Fed? As displayed in Chart 4, a Fed dot plot indicates a median expectation of the Fed funds rate reaching a high of just over 5% in 2023, according to the FOMC’s assessments made in its last meeting in December 2022^[1]. Likewise, markets expect the rate to peak around June near 5%, implied by 30-day Fed Funds futures trading on the Chicago Mercantile Exchange (or the CME), as Chart 5 shows. This anticipated trajectory of the Fed funds rate, by both the Fed and the market, may leave some room for the Treasury yields to edge higher, if not considering other factors being discussed.

Apart from risks involved in holding a short-term bond, investors of a longer-term one, such as a 10-year Treasury bond, often bear additional risk that interest rates may change over time of investment, especially during times of economic uncertainties. Therefore, an additional term premium, which compensates longer investors for the extra risk, is required. Different from the target fed funds rate, which is set by the FOMC and is observable, term premium can only be estimated by models using financial and macroeconomic variables, such as the Fed estimated Adrian, Crump, and Moench (2013), or the ACM model^[2].

Despite the good rule of thumb that a longer investment demands additional term premium, estimated results show the underlying term premium could disappear in specific intervals or under certain circumstances. As shown in Chart 6, US Treasury’s ten-year term premium has been on a downward trend since the Global Financial Crisis in 2008 and had reached record lows just before the Covid shock. A relatively long time of near-zero rate regimes from 2009 through 2015 eroded much of the term premium even before the following round of tightening 2016-2018, plus a short-lived recovery of the term premium during the Covid-related monetary easing wasn’t as powerful as the one between 2007 and 2008. After fluctuating around zero for many months, the term premium ended 2022 at a slightly negative value and does not seem to have the momentum to increase significantly.

Lastly, let’s look at how long-term yields have historically behaved in the period immediately following policy rate hikes. Chart 7 shows that going back forty-eight years, 10-year yields tend to fall by ~50 bps and ~30 bps respectively in the six and twelve months after the last rate hike.