Buried Treasuries: Why This Selloff Might Not Be Over

What happened last week?

US

• The Federal Reserve (the Fed) held interest rates steady for a second time.

Europe

• Eurozone inflation sank to a two-year low in October.
• The bloc’s economy shrank by 0.1% last quarter from the one before.
• The Bank of England (BoE) also left rates unchanged for a second time.

Asia

• The Bank of Japan (BoJ) further relaxed its “yield curve control” program.
• Manufacturing activity in Asia slumped again in October.

What does all this mean?

After 11 hikes since March 2022, the Fed held interest rates steady for a second meeting in a row, leaving its key rate at a 22-year high of 5.25-5.5%. While the central bank left open the possibility of another hike if its fight against inflation stalls, it acknowledged that the recent sharp rise in Treasury yields reduces the need to raise interest rates again. That suggests the Fed may be done with its most aggressive monetary tightening cycle in almost a half-century, with traders betting we won’t see any more hikes.

Consumer prices in Europe rose by just 2.9% in October from a year ago – down from 4.3% the month before and lower than the 3.1% estimated by economists. What’s more, that’s the slowest rate of consumer price gains since July 2021. Core inflation, which excludes the more volatile energy and food prices and is closely watched by the European Central Bank (ECB), also fell more than expected – to 4.2%, down from 4.5% the previous month.

The falling price pressures come after ten consecutive ECB interest rate hikes, which have been bringing inflation down by slowing consumer spending and business investment, and unfortunately also creating a knock-on effect for economic growth. Case in point: data last week showed the eurozone economy shrank by 0.1% last quarter from the one before, which was worse than the 0% “stagnation” level that was expected.

The BoE held interest rates steady for a second meeting in a row, leaving its benchmark lending rate at a 15-year high of 5.25% and saying it’s still much too early to be thinking about rate cuts. And for good reason: Britain’s inflation rate is still triple the central bank’s 2% target, and is the highest among the Group of Seven nations. And though the BoE’s rate hikes haven’t obliterated the country’s inflation, as intended, they do appear to be doing a number on its economic growth. That’s got the central bank warning that the economy might stagnate over the coming year, raising new doubts about how long it could hold rates at the currently elevated levels.

In Japan, the BoJ decided to allow the 10-year government bond yield – a key long-term interest rate – to exceed 1%, marking the second revision to its yield curve control program in three months. The Bank has been under increasing pressure to adopt a less stimulative monetary policy stance, as it’s faced a weakening yen, rising bond yields, and above-target inflation. On that last point, the BoJ recently revised its core inflation forecast upward to 2.8% for the 2024 fiscal year, from its previously forecast 1.9%.

Manufacturing activity in Asia, which makes much of the world’s goods, took a hit in October. The latest manufacturing purchasing managers’ indexes (PMIs) showed activity shrank last month as countries including Japan and South Korea felt the squeeze from rising costs, reduced production, and fewer new orders. Meanwhile, a private gauge of factory activity in China unexpectedly shrank, highlighting the fragility within the world's second-biggest economy.

This week's focus: US Treasuries

Expectations that the Fed will keep interest rates at their current high levels for longer and that the US government will have to sell loads of bonds to cover its widening budget deficit have sent the prices of Treasury bonds tumbling. In fact, the prices of Treasuries with maturities of ten years or longer have now declined by nearly 50% since their March 2020 peak, putting them on course for an unprecedented third year of annual losses. Over the same period, the 10-year Treasury yield has climbed more than four percentage points. Last month, it popped above 5% for the first time in 16 years. (Remember, bond yields rise as their prices fall.) We haven’t seen this kind of boom in yields since the early 1980s when the Fed’s efforts to combat inflation (sound familiar?) drove rates up and plunged the US into back-to-back recessions.

The problem is, the 10-year yield could head higher still. A recent study by Bloomberg Economics suggests that the cumulative effects of persistently heavy government borrowing, increased spending on climate change initiatives, and accelerated economic growth could result in a 10-year Treasury yield of around 6% in the long run. Should that happen, it’s not just bond investors who might feel the pain: the 10-year Treasury yield is often considered “the risk-free rate” against which all other investments are measured. So a higher yield could lead to declining values in other asset classes too. What’s more, the yield impacts borrowing rates for households and businesses because it serves as a benchmark for the cost of money across the financial system.

The week ahead

• Monday: Eurozone sentix economic index (November), China trade balance (October).
• Tuesday: Japan household spending (September). Earnings: Uber, Rivian, Gilead, Occidental.
• Wednesday: Eurozone retail sales (September), China loan growth (October). Earnings: Disney.
• Thursday: China inflation (October).
• Friday: UK economic growth (Q3).