US 10-year Treasury yields rose as high as 4.88% in the first week of October, their highest level since 2007 and up by around 100 basis points relative to their level in July. The result has been a significant tightening of financial conditions in the US economy. The extent and speed of the move means negative economic consequences cannot be excluded (see turmoil in US banking in March 2023).
It may be a desire to reign in the tightening in financial conditions that led Federal Reserve Bank of Dallas President Lorie Logan to note on 9 October that the surge in long-term Treasury yields may lessen the need for the Fed to raise its benchmark interest rate again. Her comments were followed by observations from Fed Vice Chair Philip Jefferson, who pointed out that the tightening of financial conditions and the sharp increase in long-term real yields were doing some of the hard work for the Fed. In his view, the “fabled sufficiently restrictive level” has been reached.
In the wake of these comments, and the latest events in the Middle East, US 10-year yields fell as much as 18 basis points to 4.62%, the biggest one-day decline since March. Two-year yields slipped 16 basis points to 4.92%.
The rise in US bond yields over the last two months has nonetheless brought about a comprehensive shift in longer-term rates. As the chart of the week shows, from an inversion of the US yield curve as recently as July of around 108 basis points (the extent to which 2-year yields exceeded 10-year yields), the difference fell to 32 basis points, the least inverted the yield curve has been in almost 12 months.
This change in the yield curve has been driven by a ‘bear steepening’ of the yield curve. That is, yields of longer-dated bonds rising faster than those of short-dated US sovereign debt. This is partly explained by a rise in the term premium – the compensation investors require for the uncertainty inherent in holding a long bond. During the quantitative easing era the term premium was suppressed. Today, quantitative tightening, debt sustainability worries, and structural inflation risk arising from deglobalisation and the energy transition, for example, may be among the factors pushing the term premium higher. Should this trend overshoot, it could inflict serious damage to risk assets and the economy. Hence perhaps, the efforts from Fed members to reign in the tightening in financial conditions.