The Fed Already Has a Cap on Long-Term Bond Yields
(Bloomberg Opinion) -- Last week was something of a watershed moment in the $21 trillion U.S. Treasury market. After a period of relentless selling that pushed longer-term yields to their highest levels in a year, Federal Reserve Chair Jerome Powell had one last opportunity to quell investors’ nerves before the central bank’s self-imposed blackout period.
Instead, he said that he’s not too bothered by the moves and that traders are on their own. Mic drop.
This kind of attitude naturally raises the question of just how high longer-term Treasury yields can go from here, given expectations for one of the biggest years of U.S. economic growth in decades. The benchmark 10-year yield is already up 66 basis points since the start of the year, on pace for the fourth-steepest quarterly climb since the 2008 financial crisis. Could it soon reach 2%, or 2.5%, or even 3%?
As I’ve noted before, the Fed only has direct control over shorter-term rates while longer-term yields are more prone to move based on market expectations for economic growth and inflation. But that’s not to say the central bank has no say at all over the long end of the yield curve. Its “dot plot,” which shows policy makers’ projections for the fed funds rate, includes median estimates for not just the next few years but also the “longer term.” Currently at 2.5%, this is the “neutral rate” at which monetary policy is neither accommodative nor restrictive and keeps the economy at maximum employment with inflation around 2%. In the first dot plot in 2012, the median longer-term rate was 4.25%.
Almost without fail, the Fed’s longer-term dot has served as a soft cap on longer-term Treasury yields. While it’s certainly possible that this economic recovery will be different from the last one because of supportive fiscal policy and the central bank’s new monetary-policy framework, for now it should be considered a guidepost for bond traders about just how far the selling can go.
A chart of the 30-year bond yield relative to the longer-run neutral rate tells a clear story. It’s likely little coincidence that selling abated at the end of 2013 right around the time the long bond yield approached 4%, the same level as the median estimate of the longer-term dot. Again during the Fed’s tightening cycle, the bond yield hovered around the longer-term dot for much of 2017, 2018 and the first half of 2019. The 30-year yield touched a recent peak of 2.39% on Feb. 25 — history suggests a clear break through 2.5% will be challenging.
Comparing the 10-year Treasury yield relative to the longer-run neutral rate puts scrutiny on late 2018, when it shattered the implicit 3% ceiling and markets quickly went into a tailspin, forcing Powell to abruptly pivot and lower interest rates in 2019. Other than that brief period, the benchmark yield hasn’t come close to testing the long-run dot and remains well below it even after the steep increase of the past few months.
As it so happens, Dallas Fed President Robert Kaplan wrote an essay in October 2018, right around the time 10-year yields peaked, about the longer-term neutral rate. He even used a fiscal policy example that’s relevant to today’s markets, given the $1.9 trillion bill making its way through Congress:
Estimates of the “longer-run” neutral rate are typically influenced by nonmonetary drivers which reflect more enduring secular factors such as expected medium-term growth in the workforce and the expected rate of increase in labor productivity. Productivity growth, in turn, is influenced by investment in capital equipment and technology, regulatory policies, and policies which impact the education and skill levels of the U.S. workforce. In addition, the longer-run neutral rate is likely to be influenced by trends in the global supply and demand for safe and liquid financial assets.
To illustrate the difference between short- and long-run measures, I will use an example regarding fiscal policy. If the federal government passes a substantial tax cut or increases government spending, it may create a short-term stimulus that materially increases near-term GDP, which will likely be accompanied by an increase in the shorter-run neutral rate. However, if these policies do not fundamentally increase the medium- or longer-term growth potential of the U.S. economy, they may have only a marginal impact on the longer-run neutral rate.
This strikes at the heart of the question that bond traders are grappling with right now. Economic growth this year will be good — and perhaps spectacular. Pent-up demand and savings could revive long-dormant inflation and get the Fed away from the zero lower bound within the coming years. Few would argue that the shorter-run neutral rate should be higher than it was just a few months ago, when the outlook for vaccinations was far less certain.
But has anything changed enough to nudge the longer-term neutral rate higher from 2.5%, where it has been since June 2019? Let’s just say I wouldn’t expect it to move up when the central bank releases its updated dot plot after its coming March 17 decision. It’s also worth noting that in June 2019, seven of 16 central bankers estimated the longer-term rate to be higher than 2.5%, and only one saw it lower, at 2.375%. Now, just three of them have their dot above 2.5%, while five are less than 2.5%.
This might be of little comfort to owners of Treasuries, which according to research from Deutsche Bank’s Jim Reid are off to their third-worst start to a year since 1830, or holders of U.S. investment-grade corporate bonds, which haven’t lost this much to start a year since 1980. The same goes for those who bought near the top of the rally in high-flying technology shares.
But just because Powell didn’t sweet-talk markets doesn’t mean there are no brakes on Treasuries. It’s easy to forget that even though 10-year yields have tripled since August, they’re barely 20 basis points higher than their pre-pandemic record low. Meanwhile, 30-year yields haven’t yet tested 2.5%. The Fed’s tacit upper bound has served it well over the past decade — until proved otherwise, bond traders should assume it’ll hold firm again.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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