US 10-year Treasury yields are expected to average 4.2% over the long term, according to the Swiss Re Institute, a figure 40 basis points above its previous forecast.
Long-dated US Treasury bonds have sold off sharply this autumn, surprising many investors and taking yields on the benchmark 10-year bonds to levels last seen in 2007, analysts explain.
This compares to the first half of 2023, when long-dated Treasury yields remained low, depressed by expectations that the Fed would cut policy rates quickly and deeply in response to an expected recession in late 2023 or early 2024.
Now, the Institute forecasts a milder economic slowdown in the US accompanied by only about 75bps of rate cuts next year.
According to the report, this implies that policy rates will remain restrictive for some time and long-end bond yields are unlikely to fall sharply from current levels.
“The sharp sell-off in US 10-year Treasury bonds this autumn has primarily reflected markets coalescing around expectations of a higher natural long-term policy rate, greater inflation volatility, and a shrinking Fed balance sheet. We see these trends maturing further and now see 10 year US Treasury yields averaging 4.2% over the long term: 40 basis points above our previous forecast,” the Institute highlighted.
Analysts now believe that the Federal Reserve’s long-term policy rate has moved higher from 2.5% to 3%, supported by a higher “natural” rate of interest. They estimate the US natural policy rate, at which monetary policy is neither restrictive nor accommodative, at about 3-3.25%, to date (Nov 27, 2023).
“This is consistent with the latest projections from the Fed’s open market committee, which show a widening range for the neutral policy range of 2.4-3.8%. Market pricing of the long-run neutral rate can be proxied by the one-year Treasury yield in 10 years’ time,” the Institute noted.
Future policy rates reflect inflation and growth expectations, which could lead to the emerging belief on the Fed that inflation will be more volatile in the years ahead, according to the report.
This would be mainly influenced by a number of structural factors, namely demographics, decarbonization, deglobalisation, and higher debt levels. Greater public spending on the green energy transition could also raise long-run GDP growth by fortifying the supply side of the economy.
Additionally, advances in artificial intelligence may further unlock productivity improvements that support stronger long-run economic growth, contributing to higher policy rates and consequently sovereign bond yields.
“The long end of the yield curve has also seen the 10-year term premium,” analyst note, “the extra compensation investors demand for holding longer-dated government debt, rise sharply in H2 2023. The term premium can be proxied by the difference between short-term policy rates and 10-year yields.”
The Institute believes there are several reasons for this normalisation of the term premium to its long-term trend to continue: “First, as the Fed’s policy rate declines toward neutral from its current level, we expect a bull steepening in the Treasury yield curve to add upward pressure to the term premium as short-end rates fall below long-end rates.
“Second, we expect heightened inflation volatility to fuel demand from investors for additional yield compensation going forward, creating an additional channel through which the term premium may rise further over the long run.
“Third, research estimates that every 1% reduction in the Fed’s balance sheet holdings should steepen yield curve by roughly 3 basis points.4 Further curve steepening resulting from a shrinking Fed balance sheet is likely to exert some degree of upward pressure on the term premium.”
Finally, while the Fed’s balance sheet normalisation reduces a predictable domestic source of Treasury demand, foreign demand for Treasuries is also slowing. Despite this not being worrisome on its own, the diversification of reserves away from US Treasury notes will add to upward pressure on the long end of the curve and support a higher term premium, analysts warn.
