US Treasury yields surge, cooling Fed's rate-hike prospects

Expectations for continued high interest rates and data showing a persistently resilient domestic economy have driven government bond yields to new highs that are weighing on the prospects for future policy tightening from the Federal Reserve.

The benchmark US Treasury 10-year yield closed at 4.91% on Oct. 19, its highest level since July 2007, and appears likely to breach 5% before the end of the month. The 30-year yield settled at 5% on Oct. 19 for the first time since August 2007, while the 2-year yield settled at its highest point since July 2006.

"I think we will eventually see the entire curve trade above 5%, as the market tries to figure out what the fair price is for term premium," said Patrick Leary, managing director with Loop Capital Markets.

As the sell-off in government bonds continues, Fed officials will likely see these higher yields as an effective substitute for further rate hikes.

"I think it adds to the overall tightening of financial conditions and higher yields are doing the job of the Fed," said Jack McIntyre, portfolio manager at Brandywine Global. "Two big emotions always drive markets: fear and greed; and Treasury markets are reflecting sentiment more aligned with extreme fear, driven by the premise of inflation being sticky."

Substitution for rate hikes

The ongoing rise in bond yields serves as the equivalent of about a single 25-basis-point rate hike and would likely reduce the necessity of further hikes from the central bank, Federal Reserve Bank of San Francisco President Mary Daly said during an Oct. 5 appearance at the Economic Club of New York.

"The need to do tightening additionally is not there," Daly said.

The Fed has already raised its benchmark federal funds rate by 525 basis points since March 2022 in an effort to bring inflation growth down to a 2% target.

In his opening remarks at the Economic Club on Oct. 19, Fed Chairman Jerome Powell said longer-term bond yields have been an "important driving factor" in the tightening of financial conditions.

"We remain attentive to these developments because persistent changes in financial conditions can have implications for the path of monetary policy," Powell said.

The odds of a 25-basis-point hike at the Fed's next meeting disappeared Oct. 19 following Powell's comments, dropping from about 30% a month earlier, according to the CME FedWatch Tool, which measures investor sentiment in the fed funds futures market. The odds of a hike at the Fed's December meeting were at about 31%, down from about 37% a month ago.

Real yields

Whether the Fed hikes rates could hinge on the direction of Treasury yields at the time of the next two meetings.

"It should have a key role," said Padhraic Garvey, regional head of research, Americas, with ING. "The funds rate is high enough as is. Keeping it here is all the Fed needs to do at this juncture. That in itself will pile ongoing pressure on the economy. No more hikes are required."

The rise in yields has been at least partly driven by higher real yields, which measure the return on Treasury bonds minus inflation. Real yields, which have spent years in negative territory, have begun to climb as the Fed's rate hikes have taken root.

Still, the labor market remains tight, with unemployment still below 4% and job openings well above pre-pandemic levels, while inflation remains well above the Fed's target. These factors may boost the odds of another Fed rate hike before the end of the year.

"Many market participants would like to think that the Fed is done hiking but I think the current inflation data, labor market data, and retail sales numbers don't support taking that view just yet," said Leary with Loop Capital Markets. "The main reason that everyone seems to want to call the top here is all about the lagging effect of monetary policy and that rates have come so far so fast."

The rise in bond yield may make Fed officials hesitant to hike more, but an acceleration in growth and inflation would likely force them to, said Gennadiy Goldberg, director and head of US rates strategy at TD Securities.

"Right now the market is pushing rates higher on a combination of 'higher for longer' expectations and expectations of higher deficits," said Goldberg. "The big risk is that the higher rates lead to a nonlinear break in markets by creating a shock to the economy, but of course, such nonlinear breaks are always very difficult to see."