Yields on U.S. Treasury bills and notes have been rising more than might be expected in a period of still relatively low inflation. We asked two of our portfolio managers responsible for intermediate- and short-term fixed-income strategies, Don Ellenberger and Sue Hill, respectively, for their perspectives.
Ellenberger: Interest rates have been marching higher in fits and starts since the summer of 2016 when 10-year Treasury yields touched a multi-decade low of 1.36%. While the 10-year has more than doubled, there are several reasons to believe that we haven’t yet seen the peak in yields.
Perhaps the most significant reason is a seismic shift in the supply-and-demand equation for bonds. In recent years, the biggest bond buyers have been the Federal Reserve, foreigners and mutual funds, but that may be changing. As the Fed pares its balance sheet, it will buy fewer and fewer Treasury bonds and agency mortgage-backed securities. As rates creep higher overseas in response to the gradual removal of policy accommodation in Europe and Asia, foreign buyers will have less incentive to hunt for yield in U.S. bonds. And retail investors, who have poured massive amounts of money into bond mutual funds because cash had a near-zero yield, can now park money in T-bills and earn close to 2% with no risk of loss.
In contrast, the supply of Treasuries is rapidly rising. The government needs to sell more and more to finance a growing federal deficit due to diminished tax revenue (thanks to the tax cuts), increased spending (thanks to the recent 2-year budget agreement) and less buying from the Fed. At the same time, the Fed may raise rates if inflation picks up, and there’s a host of reasons that could occur: acceleration in wages, a weaker dollar, rising commodity prices, growing risks of protectionism, overseas cash repatriation.
While 10-year Treasury yields have tested 3% recently, they have not traded above it. This may be because a wobbly stock market has injected a modest flight-to-quality bid into the Treasury market. But with no recession in sight, a deteriorating supply/demand picture and rising inflation risks, it’s not difficult to see 10-year yields moving above 3% this year, the only questions being how far above and how fast.
Hill: In the last few weeks we’ve seen yet another chapter in the atypical behavior of the Treasury market since the financial crisis and multiple rounds of Fed quantitative easing ( ). One would expect the shortest end of the yield curve to climb toward the new federal funds target range of 1.50-1.75% that policymakers are widely anticipated to announce next week, and that has been happening. In fact, the 1-month Treasury bill actually has been above 1.50% since the days after new Fed Chair Jerome Powell testified before Congress in late February.
But the recent surge in yields isn’t just due to anticipated Fed moves—enormous Treasury issuance also has played a starring role. In addition to the aforementioned reasons (to finance governmental spending and make up for lost tax revenue), the Treasury has wanted to hold a more robust cash-balance position as a matter of prudent policy in order to protect against a potential interruption in market access. Debt-ceiling battles have scuttled previous attempts to build and subsequently maintain this stockpile, so when the debt ceiling was suspended in early February, the Treasury ratcheted up issuance out of the gate as soon as they got the green light.
For the money markets, it’s not just that the Fed is buying fewer bonds as part of the taper but as the Fed holdings roll off, the Treasury needs to reissue to the private sector in order to pay the Fed back. Treasury officials have indicated that a quarter to a third of the total tapering repayments could be reissued in the form of Treasury bills, adding to the supply at the front end of the yield curve. This has pushed repo rates higher and made collateral so plentiful that few participants need to use the Fed’s reverse repo facility that sets the floor on overnight trading. As the Fed hikes rates, a key will be that how much the ongoing issuance is absorbed in the market.