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Federal Reserve Chairman Jerome Powell said the central bank would take a cautious approach to raising interest rates.
Chen Mengtong/China News Service/VCG/Getty Images)
When it comes to interest rates, we go back to the future.
The benchmark 10-year Treasury yield briefly broke 4.5 percent last week, widely considered the highest level since 2007. This makes it seem like this was something out of the ordinary. In reality, it represented nothing more than a return to normality.
That 4.5% yield represents the long-term average for U.S. Treasury bonds, and by that we really mean long-term bonds dating back to 1790. Credit for this observation goes to Jim Reid, head of global fundamental credit strategy at Deutsche Bank.
“In some ways this could be seen as worrying as we are ‘only’ at normal historical levels, although inflation is still high and record peacetime deficits are predicted for the rest of your career, no matter how old you are,” he commented in one of his always informative Chart of the Day notes.
“The good news is that at least the value has returned. “It will be much harder for longer-term investors to lose money in government bonds, as this has been the case for most of the last decade, both in nominal terms and, to a lesser extent, in real terms,” he added.
But this comes after staggering losses on supposedly “risk-free” government securities, some of which are selling for less than 50% of their face value. With a nod to our central bank chief, Deadhead, what a long, strange journey it has been – and a bad journey for those who own the 1.25% Treasury bonds due May 15, 2050, which were priced at 48.186 on Thursday , more, closed at more than half their original price just over three years ago.
But the question remains: are we there yet? While the Federal Reserve, as expected, left its key interest rate target unchanged at 5.25% to 5.5% at its policy meeting last week, it also confirmed that it intends to keep interest rates higher for longer.
As Fed Chair Jerome Powell mentioned earlier, policymakers would proceed cautiously. In terms of the Federal Open Market Committee’s updated summary of economic forecasts, this could mean another quarter-point increase in the Fed funds target this year to a midpoint of 5.6%. But for 2024, the FOMC median forecast now calls for a total half-point rate cut by year-end (presumably in quarter-point increments) to 5.1%, rather than a full point.
This is based on economic forecasts that expect continued growth and a further decline in inflation with a smaller increase in unemployment than previously expected next year, a fortuitous combination that Bruce Kasman, JP Morgan’s chief economist, described in a Bloomberg television interview as ” “desirable”.
Given that short-term interest rates are well in the 5% range through 2024, last week’s 4.5% 10-year Treasury rate does not appear to be the ultimate target. According to Jawad Mian, founder and editor-in-chief of Stray Reflections, an independent global macro research and trading advisory firm, history shows that the Federal Reserve interest rate and the 10-year Treasury note have tended to peak at around the same level.
What’s different this time is that the Fed’s previous quantitative easing has reduced the so-called term premium (the additional return for holding longer maturities, analogous to the equity risk premium for stocks) by perhaps a full percentage point. As the Fed reduces its holdings of Treasury bonds while the federal government faces an $18.8 trillion deficit in the coming decade, the Congressional Budget Office estimates that the term premium is likely to rise and boost yields, he writes in a note to clients.
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Chris Verrone, head of Strategas’ technical and macroeconomic research team, also sees in his charts that the 10-year Treasury note will rise to 5.1% to 5.2% after breaking above its previous high of 4.36% . Additionally, he sees the stock market becoming choppy as interest rates rise.
Cyclical stocks stopped outperforming defensive stocks last month, he emphasized in a note to clients. And while the S&P 500 Index remains well above its August lows and 200-day moving average, supported by the Magnificent Seven big-cap technology stocks, the equally weighted S&P 500 has broken below both marks.
Investors who have weaned themselves off historically low interest rates now have to deal with money that no longer costs nothing, or even less when inflation is taken into account.
Write to Randall W. Forsyth at [email protected]