Interest rates on mortgages, credit cards and business loans have soared in recent months, even as the Federal Reserve (Fed) has left its policy rate unchanged since July. This rapid rise surprised investors and put policymakers in a delicate situation.
The focus has been on the 10-year U.S. Treasury yield, which underpins many other borrowing costs. That yield increased by a percentage point in less than three months, briefly surpassing 5% for the first time since 2007.
This and other abrupt and unusually sharp rises sent shockwaves through financial markets, leaving investors perplexed as to how long rates can remain at such high levels “before things start happening.” to collapse markedly,” said Subadra Rajappa, head of U.S. rates strategy at Société Générale.
So what is happening?
Strong growth and stubborn inflation
Initially, when the Fed began to fight inflation, it was short-term market rates – like the yield on two-year bonds – that rose sharply. These increases closely followed hikes in the Fed’s overnight lending rate, which rose from near zero to more than 5% in the span of about 18 months.
Longer-term rates, like 10-year and 30-year Treasury yields, have moved less because they are influenced by factors that have more to do with the economy’s long-term outlook.
One of the most surprising results of the Fed’s rate-raising campaign, which aims to contain inflation by slowing economic growth, has been the resilience of the economy.
While short-term rates are primarily tied to what’s happening in the economy right now, longer-term rates take more into account perceptions of how the economy will fare in the future. However, these have changed.
From June to August, changes in the 10-year yield reflect changes in Citigroup’s Economic Surprise Index, which measures the difference between forecast economic data and actual numbers when they are released. Lately, the index has shown economic data to be consistently higher than expected, including on Thursday, when the government reported a surprisingly large rise in gross domestic product last quarter. The improving growth outlook has led to a rise in long-term, market-based interest rates, such as the 10-year yield.
A trajectory of “higher” rates for longer
Better-than-expected employment and consumer spending figures are good news for the economy, but they make the Fed’s role in slowing inflation more difficult. So far, growth has been maintained while inflation has moderated.
But the economy’s resilience also means that the rise in prices has not slowed as quickly as the Fed – or investors – had hoped. To fully control inflation, interest rates may need to stay “higher longer,” which has recently become a Wall Street mantra.
At the end of June, investors estimated a roughly 66% chance that the Fed’s policy rate would end next year at least 1.25 percentage points below its current level, according to CME FedWatch. This probability has since fallen to around 10%. This growing sense that rates won’t fall very soon has helped support the 10-year Treasury yield.
Deficits, demand and term premium
Typically, investors demand more – that is, a higher return – to lend to the government over a longer period of time, to account for the risk of what might happen while their money is immobilized. In theory, this additional return is called a term premium.
In reality, the term premium has become a sort of catch-all for the part of the return that remains after taking into account more easily measurable elements like growth and inflation.
Although the term premium is difficult to measure, there is consensus that it has increased for several reasons, which also pushes overall yields higher.
A large and growing federal budget deficit means the government must borrow more to finance its spending. However, it might be difficult to find lenders, who might want to stay away from the volatility of the bond market. When bond yields rise, prices fall. The last 10-year Treasury bond issued in mid-August has already lost nearly 10% of its value since it was purchased by investors.
“Until it becomes abundantly clear that the Fed is done raising interest rates, some investors will be less inclined to buy,” said Sophia Drossos, economist and strategist at Point72.
Some of the largest foreign holders of Treasuries have already started to withdraw.
In the six months to August, China, the United States’ second-largest foreign creditor, sold more than $45 billion in Treasury bonds, according to official data.
The Fed, which holds much of the U.S. government debt it purchased to prop up markets during turbulent times, has begun reducing the size of its balance sheet, reducing demand for Treasuries just as the government needs to borrow even more.
As a result, the Treasury Department must offer a greater incentive to lenders, which means higher interest rates.
What is the impact ?
The ramifications extend beyond the bond market. Rising yields are trickling down to businesses, home buyers and others, and investors fear these borrowers will be squeezed out.
Investors analyze earnings reports to learn how companies are coping with rising interest rates. Analysts at Goldman Sachs noted earlier this week that investors have focused on companies best prepared to weather the coming storm, avoiding companies “most vulnerable” to rising borrowing costs.
Rising rates weigh on stocks. The S&P 500 has lost about 9% since its peak in late July, a decline that coincides with rising yields.
This article was originally published in The New York Times.