“Neutral rate” creeping higher? Oh dearie! Bloodbath at the long end.
By Wolf Richter for WOLF STREET.
The 10-year Treasury yield jumped 14 basis points today to 4.49%, the highest since October 2007. Bond prices fall when yields rise, so this was quite a bloodbath today at the long end of the Treasury market.
“Neutral rate” creeping higher? Oh dearie!
It seems the Treasury market is gradually reading the memo that has been passed around for about a year. The subject line says: “Higher for longer,” and yesterday someone scribbled next to it, “maybe forever?”
Yesterday’s “dot plot” from the Fed underlined a few things in that memo. It indicated shockingly that the policy rates might still be 5.25% at the end of 2024, rather than 4.75% top of range, as it had indicated in June.
And there was discussion about the “neutral rate” creeping higher, which Powell cited as a possible reason why the economy has performed surprisingly well despite higher rates. The neutral rate creeping up and returning to the pre-QE levels of 2007 and before would introduce the “higher for maybe forever?” nuance, where the whole rate framework shifts higher, where rate cuts might not be as deep, and wouldn’t be maintained for long — unlike perma-ZIRP of yore — before getting raised to the neutral level again, which would be much higher than it was over the past 15 years (I posted an explanation and example of the neutral rate into the comments below).
The 40-year bond bull market ended in August 2020, when the 10-year yield kissed 0.5%. With hindsight, we can say that predictions at the time of the 10-yield yield dropping below 0%, as it had done in Europe, were rather silly. But on that day, we were biting our nails, because crazy things were happening all over the place, with central banks were printing trillions of dollars and throwing them at the markets.
At any rate, that zoo is over now, thank-goodness. The 10-year yield has jumped by 400 basis points since then. The world is normalizing – maybe even the “neutral rate.” And that’s a good thing.
Turns out, historically, the 10-year yield is still relatively low. We’re just not used to it anymore:
Bond bloodbath at the long end.
Future bond buyers are licking their chops at the juicy future yields they see coming at them. Current bondholders that intend to hold to maturity don’t need to worry about it. But bondholders that are wanting to trade, or that have to mark to market, or that invested in a long-term bond fund that by definition trades, that’s where the bloodbath happened.
For example, the iShares 20+ Year Treasury Bond ETF [TLT], which focuses on Treasury bonds with a remaining maturity of 20 years or more, fell 2.6% today and has plunged by 47% from the peak in said August 2020. If long-term interest rates continue to rise, the price will continue to fall.
This instrument is good for betting on the direction of interest rates. But as interest rates fell for most of the 20 years of the life of this fund, interrupted by some increases, the price of the ETF kept rising and made great money, and buy-and-holders began confusing it with a low-risk long-term yield investment, which it is not.
The unloved 20-year yield – “unloved” because it has been higher than the 30-year yield ever since the 20-year Treasury security was introduced in May 2020 – spiked 17 basis points today, to 4.74%, closing in on that fabulous 5%. By contrast, the 30-year yield spiked 16 basis points to 4.56%.
Sanguine at the shorter end today.
The two-year yield closed at 5.12%, same as yesterday, and just a few basis points higher than in the prior days. So that’s the highest since 2006. But compared to the 1990s and 1980s, the yield remains relatively moderate:
The three-month yield has been steady, closing at 5.57% today. The Effective Federal Funds Rate (green) has been at 5.33% since the last rate hike in July, with a spread of 26 basis points to today’s three-month yield. This spread shows that the three-month yield has fully priced in a rate hike by November.
The drama is on the long end of the Treasury yield curve, with the 10-year yield, and up, where the reckoning has been taking place for months that the bond market is in a new era, that the 40-year bond bull market died, that long-term yields are no longer repressed by massive QE, that in fact the Fed is shedding assets, closing in on the $1-trillion mark in terms of what it has shed since the beginning of QT, just when the government is issuing a tsunami of longer-term Treasuries, and that there is now the suspicion floating around that the “neutral rate” has been creeping up.
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