Don't look now, but interest rates are breaking out to new sixteen-year highs. The 10-year yield is just a breath away from 4.5%. Yes, jobless claims were shockingly good this morning, but the jump in yields started overnight, before we got that data. Among a zillion other things, it means mortgage rates will yet move higher.
But wait a minute--didn't the Fed just pause on rate hikes at its meeting yesterday? Yes. They've left the overnight rate at current levels, around 5.3%. Still, they also signaled a lower chance of rates dropping anytime soon. Their new forecast showed only one or two rate cuts next year, down from three or four in the last one. Hence longer-term yields are shifting upwards in response.
The simple, optimistic story to tell here would be that the economy has been more resilient than expected, and so the Fed wants to keep policy tighter for longer to make sure inflation doesn't accelerate again. That's not the whole story, however. In fact, there's a growing sense of caution about the outlook right now--with evidence mounting that GDP could hit a fourth-quarter "pothole," as Goldman is calling it.
Indeed, the stock market's behavior seems to confirm the unease. The S&P 500's sharp year-to-date rally began stalling out in August, and stocks are selling off again this morning on the upward move in rates. Having failed to break out to new highs this year, the market remains about 8% lower than its year-end 2021 all-time high close of nearly 4800.
So what's really going on? Greg Ip of The Wall Street Journal notes that the breakout in Treasury yields this year really picked up steam on something that used to go almost unnoticed in markets--the Treasury's refunding announcements. Their early August updates in particular showed a much bigger borrowing need--$1 trillion in the third quarter, up from their $733 billion May estimate--thanks to soaring budget deficits.
And perhaps it's no coincidence that stocks have since stalled out. It's one thing to have rising bond yields on the back of economic enthusiasm that can lift all risk assets (which we saw, to some extent, in the first half of this year). It's quite another to have rising bond yields because there's too much government debt for markets to swallow, which poses a longer-term threat to the economy.
A glance at this situation globally confirms this dynamic. Why else would German yields be at near-decade highs while their economy is in its third quarter of recession? Germany's debt issuance has jumped by 20% this year alone, as it has turned to more borrowing to help it weather the energy crisis stemming from Russia's war on Ukraine.
Even Japan, where growth has surprised to the upside, factors into the global supply glut; the Japanese have long been major buyers of U.S. Treasuries, but their holdings have fallen over the past year as their own yields offer higher returns. Indeed, foreign ownership of U.S. Treasuries overall has fallen from about 45% a decade ago to just 30% today, according to economist Peter Boockvar. And that's as the total amount of outstanding Treasuries has soared from just $5 trillion in 2008, to more than $25 trillion today.
And amid all of this, global central banks are also no longer the massive buyers of government debt that they were last decade, when engaged in massive "quantitative easing" to try and lower bond yields to stimulate their post-crisis economies. Indeed, they're now doing quantitative tightening, or in other words, trying to run down their massive balance sheets by offloading securities.
It feels like a long time since we've seen yields being driven by supply rather than demand factors, but it's hard to ignore the mounting evidence that we're seeing precisely that dynamic seeping into markets. And it may be why "real" rates keep rising. Actual, inflation-adjusted rates have more than doubled just since April, if you use 10-year TIPS as a proxy. At 2.1%, we're now back to pre-crisis levels.
At first, rising real rates were seen as a positive; a sign the Fed was finally bringing the financial system back into balance after the sharply negative rates we had during the pandemic that ultimately triggered soaring inflation. But if real rates keep rising from here--especially if the economy starts to weaken at the same time--policy makers will have to figure out how to throw the brakes on. And the answer to that may come as much from Capitol Hill, already in the throes of a spending fight, as from the Fed's offices.
See you at 1 p.m!
Kelly
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