Interest rates on mortgages, credit cards and business loans have risen sharply in recent months, even though the Federal Reserve has kept its key interest rate unchanged since July. The rapid increase has spooked investors and put policymakers in a difficult position.
The focus was on the 10-year U.S. Treasury yield, which underlies many other borrowing costs. The 10-year yield has risen a full percentage point in less than three months, briefly exceeding 5 percent for the first time since 2007.
That sharp and unusually large increase, along with others, has sent shockwaves through financial markets, confusing investors about how long interest rates can stay at such high levels “before things start to break down in a significant way,” said Subadra Rajappa, chief executive of the US interest rate strategy department at Société Générale.
So what’s going on?
Strong growth and stubborn inflation
When the Fed first began fighting inflation, short-term market interest rates – such as the two-year bond yield – initially rose sharply. These increases closely followed increases in the Fed’s federal funds rate, which rose from near zero to over 5 percent in about 18 months.
Longer-term interest rates, such as 10- and 30-year Treasury yields, were less changed because they are influenced by factors that have more to do with the economy’s long-term outlook.
One of the most surprising results of the Fed’s rate-hiking campaign, designed to curb inflation by slowing economic growth, has been the resilience of the economy. While shorter-term interest rates are largely tied to current economic activity, longer-term interest rates take greater account of ideas about how the economy is likely to develop in the future, and these have changed.
From June to August, changes in the 10-year yield reflect changes in Citigroup’s economic surprise index, which measures how much economic data forecasts differ from actual numbers at the time they are released. Lately, this index has shown that economic data has consistently been stronger than expected, including on Thursday when the government reported a surprisingly strong increase in gross domestic product for the latest quarter. As growth prospects have improved, long-term market-based interest rates such as the 10-year yield have increased.
A “higher and longer” tariff path
Better-than-expected jobs numbers and consumer spending are welcome news for the economy, but make the Fed’s role in slowing inflation more difficult. So far, growth has held up as inflation has eased.
But the economy’s resilience has also meant that price increases have not eased as quickly as the Fed – or investors – had hoped. To fully control inflation, interest rates may need to stay “higher for longer,” which has become a Wall Street mantra of late.
According to CME FedWatch, at the end of June, investors estimated a probability of around 66 percent that the Fed’s key interest rate would be at least 1.25 percentage points below current levels next year. This probability has now fallen to around 10 percent. This growing sense that interest rates won’t fall any time soon has helped support the 10-year Treasury yield.
Deficits, demand and the “term premium”
Typically, investors demand more – that is, a higher rate of return – to lend to the government over a longer period of time to account for the risk of what could happen while their money is tied up. This additional return is theoretically known as a “term premium.”
In reality, the term premium has become something of a catch-all term for the portion of the return that remains after accounting for more easily measurable parts like growth and inflation.
Although the term premium is difficult to measure, the consensus is that it has increased for several reasons – and that is also driving up total returns.
A large and growing federal budget deficit means the government must borrow more to finance its spending. However, it could be challenging to find lenders willing to ride out the volatility of the bond market. When bond yields rise, prices fall. The last 10-year Treasury bond issued in mid-August has already fallen in value by almost 10 percent since investors bought it.
“Unless it is clear that the Fed is done raising rates, some investors will be less willing to buy,” said Sophia Drossos, an economist and strategist at Point72.
Some of the largest foreign holders of government bonds have already begun to withdraw. China, the U.S.’s second-largest foreign creditor, sold more than $45 billion of its Treasury holdings in the six months through August, according to official data.
And the Fed, which owns a large portion of the U.S. Treasury bonds it has bought to support markets in turmoil, has begun shrinking the size of its balance sheet, reducing demand for Treasury bonds just as the government is doing even more have to take out loans.
Therefore, the Treasury needs to provide more incentive to lenders, and that means higher interest rates.
What are the effects?
The impact goes beyond the bond market. The rise in yields is being passed on to businesses, home buyers and others – and investors fear these borrowers could come under pressure.
Investors analyze earnings reports to learn how companies are handling higher interest rates. Analysts at Goldman Sachs noted earlier in the week that investors have focused on companies that are better prepared for an impending storm and avoided companies “that are most vulnerable to increased borrowing costs.”
The rise in interest rates is weighing on stocks. As Treasury yields rose again on Tuesday, the S&P 500 slipped 1.4 percent. The index has lost about 9 percent since its peak in late July, a decline that coincides with the rise in yields.