Turbulent times for the US Treasury market

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Like shoppers, investors are often prone to the so-called left-digit bias — the tendency to place more emphasis on the leftmost digit of a price. Indeed, when the 10-year US Treasury bond yield — a benchmark used to price assets in America and across the world — surged from the high fours to 5.02 per cent on Monday, it caused a stir in financial markets. Yields have now swung back, but still hover at post-global financial crisis highs.

Breaching the 5 per cent barrier for the first time since 2007 is a marker of how tight financial conditions are becoming in the US Federal Reserve’s rate-raising cycle, and the growing squeeze ahead for the US economy. The 10-year Treasury yield has risen more than 3 percentage points in the past two years. The high volatility and speed of the sell-off in recent weeks, at a time when liquidity in Treasury markets “remained challenged”, according to a Fed report last week, is concerning too.

There are several drivers behind the recent jump in 10-year yields, which are up from 4.6 per cent in mid-October. First, investors have cottoned on to the Fed’s “higher for longer” narrative on rates, particularly as a slew of strong economic data has backed up its rhetoric. Second, the “term premium”, or the additional yield investors need to compensate for holding long-term bonds, has probably risen, according to analysts.

The US government’s widening deficit has driven higher bond issuance, while rising spending needs and political turmoil are raising expectations for future Treasury supply too. But demand has fallen, particularly with the Fed shrinking its Treasury holdings via quantitative tightening. Belief that the underlying interest rate could be higher in the long term is also growing. This is pushing up yields, but uncertainty also remains high. While 10-year yields have been on an upward march since the Fed began raising rates, intraday swings are common. 

Elevated yields could exacerbate fiscal concerns, with spending on interest payments rising. Mortgages and corporate bonds, which are linked to long-term Treasury yields, will become costlier. Stock valuations could be strained. Together, this raises the chance of a deeper and longer economic slowdown, which could pull down yields. Indeed, market skittishness poses its own risks, particularly when Treasury liquidity remains below historic norms. Investors looking to lock in high yields may be reticent to buy if they think prices could fall further. The risk of sharp yield movements could also threaten institutions holding large bond losses, and stoke distressed Treasury sales. 

The volatility is an inevitable consequence of investors trying to price Treasuries amid heightened uncertainty and following years of the Fed’s bond-buying. The lack of clarity on the economic outlook means a convincing narrative to anchor yields is also far off. Policymakers ought to be alive to the risks of something snapping in financial markets — and can also help to bring stability.

For the Fed, higher Treasury yields will obviate the need for further rate rises at next week’s rate-setting meeting. Outlining a clear vision for the economy will, however, be difficult. Jay Powell, the Fed chair, should at least be measured in his communications to avoid adding to the jitters. Monitoring Treasury market liquidity, and efforts to enhance it, will remain important as well.

Above all, the US needs to display fiscal prudence. The deficit as a share of gross domestic product is projected to balloon. Higher debt issuance in a market short of buyers will keep upward pressure on yields. Paralysis in the US Congress does not help. High rates, allied with lax fiscal policy and political chaos, are a recipe for a vicious cycle of rising government yields — as Britain can attest from its turmoil a year ago. But if the US has its own Liz Truss moment, the damage will not be contained to its shores.