The Days of Low Treasury Yields Are Numbered

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The 10-year U.S. Treasury note is part of the foundation of global finance. Its yield helps determine the cost of mortgages, the value of U.S. stocks and how much the U.S. government must pay to service its growing debt.

I think markets are severely underestimating how much that yield is likely to rise in coming years.

Right now, the 10-year Treasury yields about 1.6%. That’s unsustainably low, for two main reasons. First, as I argued in a recent column, the Federal Reserve is likely to raise short-term interest rates far beyond that level. Second, the added yield the government must pay to borrow for longer periods — known as the term premium — is likely to increase, too. Let’s take these points in order.

The yield of any 10-year security must incorporate expectations for shorter-term rates over the same period. So where does the Fed, which controls short-term rates, think they’re headed? In their latest projections, officials estimated that over the long run, the federal funds rate consistent with the central bank’s 2% inflation target would be somewhere between 2% and 3%. The median estimate was 2.5%. If they’re right, this should be the floor for longer-term Treasury yields. Why tie up money for 10 years if you can get the same return by lending for much shorter periods?

Now consider the term premium. Historically, it has been positive, reflecting the preference of investors for liquidity and borrowers for locking in costs. But for much of the prior expansion, it disappeared or even turned negative. I see a few explanations for this: the risk that an economic shock would again force the Fed to take short-term rates to zero, the absence of inflationary pressures, and the Fed’s increased use of long-term bond buying as a monetary policy tool.

Today, there’s ample reason to expect a positive term premium to return. For one, the Fed has a new, more patient monetary policy stance. As a result, inflation will be higher and more variable — a risk that must be compensated with higher long-term yields. Also, keeping inflation in check will require a higher peak fed funds rate, reducing the risk that the Fed will again get pinned at the zero lower bound. Beyond that, deficit financing is expanding the supply of government bonds: Treasury debt outstanding has quadrupled since 2007, and the Biden administration is seeking to add several trillion dollars more. Meanwhile, one big source of demand for the bonds is set to dwindle as the Fed phases out its asset purchases, most likely next year.

Putting the pieces together, one can expect a 10-year Treasury yield of at least 3%: The 2.5% floor set by the federal funds rate, plus a term premium of 0.5% or more. But that’s not all. The Fed says it wants inflation to exceed its 2% target for some time, to make up for previous shortfalls. This, in turn, could stoke inflationary fears and lead markets to expect a higher path for future short-term rates. As a result, the 10-year Treasury yield could more than double from the current 1.6%. And if persistent deficit financing prompts concern about growing U.S. debt, the yield could go to 4% or higher.

Anyone who has been in finance for less than a decade has rarely seen 10-year Treasury note yields above 3%. So what’s coming could, for many, be quite a shock. The secular bond bull market that began nearly 40 years ago is finally ending.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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