A series of strong economic indicators has sparked a renewed bond sell-off, causing concern in the markets and the banking sector. Last week, the yield on the 10-year Treasury note surpassed 4%, its highest level since early March, and the yield on the 2-year note reached its highest level since 2007. This increase in yields can be attributed to the unwinding of bets that the Federal Reserve’s efforts to control inflation would lead to a rapid cooling of the economy or even a recession.
While rising yields are typically associated with economic growth, they can pose challenges for investors. Last year, the Fed’s rate hikes resulted in significant losses in the bond market, which, in turn, triggered steep declines in stocks and other riskier investments as higher bond yields provided an alternative investment option.
The collapse of Silicon Valley Bank in March, driven by concerns about the declining value of its bond portfolio, led to a decrease in yields, boosting tech stocks and alleviating worries about banks’ balance sheets. However, yields are now on the rise again, and the stock market rally is showing signs of slowing down. The evidence of a resilient economy is prompting investors to align their interest-rate forecasts more closely with the Fed’s projections.
While there have been warning signs that historically carry weight on Wall Street, such as tightening lending standards and inverted yield curves, the passage of time has made these signals less reliable. Investors have been cautious about an impending recession, but the indicators have not materialized in practice.
On Friday, the yield on the 10-year Treasury note settled at 4.047% after the release of data showing a slight miss in job growth expectations for June, but higher-than-anticipated wage increases. This marked an increase from 3.818% the previous week, effectively recovering all the declines following SVB’s collapse.
The current bond sell-off exhibits some new characteristics. In previous instances when the 10-year yield crossed the 4% threshold, it was driven by weak inflation reports. However, recent data indicates that inflation remains comfortably above the Fed’s target. Encouragingly, the reports have shown hints of a slowdown in price increases for services outside of housing, an area highlighted by the Fed as significant. As a result, investors’ inflation expectations, as measured by the yield differential between regular Treasury bonds and inflation-protected Treasurys, have remained relatively stable at just above 2%.
Nevertheless, the persistence of economic strength has led investors to revise their estimates for the required increase in real rates to control prices. This is reflected in the yields on Treasury inflation-protected securities (TIPS), which have reached levels not seen in over a decade. The yield on the five-year TIPS stood at around 2.12% as of Friday, a significant increase from the negative levels seen during the early stages of the pandemic.
Given the prolonged period of inflation above the Fed’s target, investors are engaging in a reassessment of the neutral rate necessary to maintain price stability. However, not all investors believe that bond yields can remain at current levels for an extended period before retracing.
