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• 2024-10-27

Is U.S. Treasury Yield Over-Adjusted?

Core Viewpoints

The 10-year U.S. Treasury yield has risen above 4.2%. From October 22-25, 2024, the 10-year U.S. Treasury yield broke through and stabilized above 4.2%, setting a new high since July 26. The continued rise and breakthrough of the 10-year U.S. Treasury yield above 4.2% mainly reflects the further upward shift in future interest rate expectations. According to CME FedWatch, from October 11-25, the futures market's expectations for a Fed rate cut within the year remained essentially unchanged, but the interest rate expectations for after June next year shifted upwards by about 15 basis points. The 2-year U.S. Treasury yield, which has a strong indicative significance for interest rate expectations, has risen by a cumulative 16 basis points to 4.11%; the 10-year U.S. Treasury yield has risen by a cumulative 17 basis points to 4.25%, with the real rate contributing 21 basis points and inflation expectations dragging down 4 basis points.

Four Clues for the Upward Interest Rate Expectations. Since mid-October, there have been four clues behind the upward market interest rate expectations. First, the strong U.S. retail sales data led the GDPNow model to predict a new high. As of October 18, the GDPNow model's latest forecast for the third quarter U.S. real GDP growth rate on an annualized环比basis was 3.4%. Second, speeches by Federal Reserve officials conveyed a strong "hawkish" signal. On October 21, Minneapolis Fed Chairman Kashkari, Dallas Fed Chairman Logan, and Kansas City Fed Chairman Schmid all expressed support for slowing down rate cuts. Third, higher economic growth, debt growth, and inflation prospects correspond to upward support for U.S. Treasury yields. Fourth, concerns about "U.S. dollar credit" continue to ferment (signaled by the strength of gold prices), which may exacerbate U.S. Treasury selling.

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U.S. Treasury Yields May Have "Overshot". We believe that the reasonable central level for the 10-year U.S. Treasury yield this year is still around 4%, and it may be around 3.5% next year. First, the current 10-year U.S. Treasury yield may significantly exceed the neutral interest rate level. The nominal 10-year U.S. Treasury yield is around 4.2%, significantly higher than the median long-term policy rate of 2.9% forecasted by the Fed in September; the real 10-year U.S. Treasury yield exceeds 1.9%, significantly higher than the "neutral real rate" of 1.22% predicted by the latest New York Fed's LW model. Second, the rebound of the 10-year U.S. Treasury yield after the first rate cut in this cycle far exceeds the rebound in previous rate cut cycles. The 10-year U.S. Treasury yield has risen by 60 basis points since the Fed's first rate cut, significantly higher than the highest rebound of 40 basis points in 1995 (a typical "soft landing"). The space for rate cuts in this cycle is broader than in 1995, and the downward space for the 10-year U.S. Treasury yield should be more ample. Third, although the U.S. economic data rebounded in September, it may not reverse the cooling trend of employment and inflation in the past half year. We calculate that the U.S. residents' "excess savings" turned negative for the first time in May this year, basically coinciding with the "inflection point" of employment and inflation. The sustainability pressure of U.S. fiscal policy may constrain the fiscal expansion of the new administration in the opposite direction. Maintaining strong economic growth in the U.S. may enhance the sustainability of debt. From the second quarter of 2021 to the second quarter of 2024, the cumulative growth of U.S. nominal GDP was 24.2%, higher than the cumulative growth of 22.1% in the total outstanding U.S. debt during the same period. At least in the past three years, U.S. economic growth has been able to digest the growth of debt.

Risk Warning: Unexpected downward trends in U.S. employment and economy, uncertain pace of Fed rate cuts, and unexpected upward trends in global geopolitical risks, etc.

From October 22-25, 2024, the 10-year U.S. Treasury yield broke through and stabilized above 4.2%, setting a new high since July 26. However, we believe that the reasonable central level for the 10-year U.S. Treasury yield this year is still around 4%, and it may be around 3.5% next year. In other words, U.S. Treasury yields may have "overshot" at present. Specifically, the current 10-year U.S. Treasury yield is significantly higher than the neutral interest rate level and has not fully factored in the space for rate cuts in the next 1-2 years and the downward risks of U.S. employment and inflation. The trading of rising debt and inflation may also be too premature.

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10-year U.S. Treasury Yield Breaks Through 4.2%

In our report, we pointed out that from late September to mid-October, the 10-year U.S. Treasury yield quickly rose from below 3.8% to above 4%, which can be attributed to two reasons: first, the economic fundamentals and interest rate expectations, that is, the latest released September U.S. employment and inflation data were strong, and the Fed guided the market to eliminate the expectation of a single rate cut of 50 basis points; second, U.S. Treasury supply and liquidity factors, that is, the temporary surge in U.S. Treasury issuance in the new fiscal year, coupled with the decline in Fed reserve levels, further raised U.S. Treasury yields.Since mid-October, the impact of the latter may have subsided. In terms of U.S. debt supply, the total amount of U.S. outstanding debt increased sharply by more than $200 billion on October 1st, and has maintained a moderate growth since October 2nd, with an average daily increase of less than $10 billion, essentially in line with the level of the fiscal year 2024. In terms of Federal Reserve reserves, the reserve balance, which was below $3.1 trillion as of the week ending October 2nd, has rebounded for two consecutive weeks, returning to above $3.2 trillion as of the weeks ending October 16th and 23rd, mainly due to the decrease in the scale of reverse repurchase agreements. This means that the tight liquidity situation in the U.S. banking system has been temporarily eased and has not constituted upward pressure on U.S. Treasury interest rates.

The 10-year U.S. Treasury interest rate continued to rise and broke through 4.2%, mainly reflecting the further upward shift in future interest rate expectations. CME FedWatch shows that from October 11th to 25th, the futures market's expectation for a Fed rate cut within the year remained essentially unchanged, but the rate expectation for after June next year shifted up by about 15 basis points; by September 2025, the market's weighted average interest rate expectation was 3.51%, higher than the 3.37% predicted on October 11th. During this period, the 2-year U.S. Treasury interest rate, which has a strong indicative significance for interest rate expectations, has risen by 16 basis points to 4.11%; the 10-year U.S. Treasury interest rate has risen by 17 basis points to 4.25%, with the real interest rate contributing 21 basis points and inflation expectations dragging down 4 basis points.

02

Four Clues Behind the Upward Interest Rate Expectations

Since mid-October, there have been four clues behind the upward market interest rate expectations.

Firstly, the strong U.S. retail sales data has led the GDPNow model to predict a new high. Data released on October 17th showed that U.S. retail sales increased by 0.4% month-on-month in September, higher than the expected value of 0.3%, with the previous value being 0.1%. Although the industrial output and new housing starts data announced on October 17th-18th basically met expectations, the strong retail data raised the expectation for Q3 GDP. As of October 18th, the GDPNow model's latest forecast for the Q3 U.S. real GDP growth rate on an annualized quarter-over-quarter basis was 3.4%, the highest since August; as of October 25th, it slightly fell to 3.3%. It should be noted that, apart from the personal consumption expenditure (PCE) data to be announced at the end of October, all important economic data for the third quarter has been basically announced, and the indicative significance of GDPNow is strong.

Secondly, speeches by Federal Reserve officials conveyed a strong "hawkish" signal. On October 21st (Monday), against the backdrop of no key economic data announcement, the 10-year U.S. Treasury nominal and real interest rates rose by 11 basis points in a single day. The driving force behind the market interest rate expectations came from speeches by three Federal Reserve officials: Minneapolis Fed Chairman Kashkari, Dallas Fed Chairman Logan, and Kansas City Fed Chairman Schmid, all of whom expressed support for slowing down rate cuts. Only Daly, who spoke on the same day, did not make any comments on the future pace of rate cuts. It is worth noting that Kashkari mentioned the possibility of an upward revision of the "neutral interest rate" in his speech, Logan's speech also expressed support for continued balance sheet reduction, and Schmid's speech was the first since August, these additional pieces of information may have amplified the market's "hawkish" perception.

Thirdly, the Polymarket betting website showed that the probability rose from 54% on October 14th to 65% on October 22-23; during the same period, the bet on a Republican sweep increased from 38% to 49%. We pointed out in our report that higher economic growth, debt growth, and inflation prospects correspond to upward support for U.S. Treasury interest rates. However, the sharp回调 in oil prices on the week of October 18th led to a回落 in U.S. Treasury inflation expectations, temporarily offsetting the upward pressure on real interest rates. Since this week, international oil prices have stopped falling and stabilized, and the 10-year U.S. Treasury inflation expectations have also stabilized at around 2.3%, making the upward movement of U.S. Treasury real interest rates more directly reflected in the rise of nominal interest rates.

Lastly, the ongoing fermentation of "U.S. dollar credit" concerns (signaled by the strengthening of gold prices) may intensify the selling of U.S. Treasuries. In our report "Why is Gold Strengthening in Phases?", we pointed out that the continuous rise in gold prices reflects investors' concerns about U.S. fiscal and U.S. dollar credit. The recent rise in U.S. Treasury interest rates, along with the increase in gold prices, is a further reflection of the above concerns. Currently, a vicious cycle has formed between U.S. Treasury interest rates and U.S. government credit, that is, as U.S. Treasury interest rates rise, the government's interest payment pressure increases, debt sustainability weakens, U.S. Treasury credit concerns intensify, U.S. Treasuries are further sold off, and U.S. Treasury interest rates rise further.U.S. Treasury Yields May Have "Overshot"

Recently, U.S. Treasury yields have continued to rise, with a background that includes a collective strengthening of economic data in September. However, the direction of interest rates on both a single-month dimension and a medium to long-term dimension (2-10 years) is biased towards an upward trend, which may cause the downward pressure on interest rates in the short to medium term (1-2 years) to be overlooked, thereby creating the risk of "overshooting" in U.S. Treasury yields. We believe that the reasonable central level of the 10-year U.S. Treasury yield within the year is still around 4%, and it may be around 3.5% next year.

Firstly, the current 10-year U.S. Treasury yield may significantly exceed the neutral interest rate level. The current 10-year U.S. Treasury nominal yield is around 4.2%, which is noticeably higher than the median of the Federal Reserve's September economic forecast for the long-term policy rate of 2.9%; the 10-year U.S. Treasury real yield exceeds 1.9%, which is significantly higher than the "neutral real rate" of 1.22% predicted by the New York Fed's LW model (as of Q2 this year, smoothed); the implied inflation expectation of the 10-year U.S. Treasury is around 2.3%, which is also higher than the Federal Reserve's 2% target. The above neutral interest rate reference indicators have already taken into account the possibility of an increase in the neutral interest rate in the post-pandemic era. The Federal Reserve's forecast for the long-term policy rate remained basically at 2.5% from June 2019 to December 2023, and was roughly around 3% from 2016 to 2018; the LW model's neutral real rate (smoothed) averaged 0.88% from 2010 to 2019.

Secondly, the rebound of the 10-year U.S. Treasury yield after the first interest rate cut far exceeds that of previous interest rate cut cycles. This round of the 10-year U.S. Treasury yield has risen by 60 basis points since the Federal Reserve's first interest rate cut, which is the highest among the seven interest rate cut cycles since 1980, significantly higher than the highest rebound of 40 basis points in 1995 (a typical "soft landing"). Compared with the situation in 1995, the interest rate cut cycle at that time lasted only about half a year, with a total of only three cuts amounting to 75 basis points, and the policy rate ceiling dropped from 6% to 5.25%, ending the rate cuts (refer to the report "Every Time the Federal Reserve Starts to Cut Interest Rates: Economy and Assets"). At present, the Federal Reserve and the market still expect that the upper limit of this round of policy rates will gradually decrease from the peak of 5.5% to around 3.5% next year, indicating that the space for this round of rate cuts is broader than in 1995, and the downward space for the 10-year U.S. Treasury yield should be more ample.

Again, although the U.S. economic data rebounded in September, it may not reverse the cooling trend of employment and inflation in the past half year. Overreacting to single-month data has never been a wise move. Moreover, if the unexpected strength of the U.S. economic data in September may be attributed to the rapid easing of financial conditions, then the market interest rates have risen spontaneously since late September, which may put pressure on economic indicators for October and beyond. More fundamentally, we believe that U.S. employment and inflation remain on a cooling track. The Federal Reserve's "catch-up" interest rate cut of 50 basis points in September was not groundless, but the result of the continuous cooling of employment and inflation from April to July this year (the unemployment rate rose from 3.8% to 4.3%, and core PCE fell from 3.0% to 2.6%). To add a recent observation: we have calculated that based on the continuous growth trend from 2016 to 2019 as a benchmark, the "excess savings" of U.S. residents turned negative for the first time in May this year, basically coinciding with the "inflection point" of employment and inflation.

Among them, we further consider two key issues: First, whether the sustainability pressure of U.S. fiscal policy will constrain the fiscal expansion of the new administration in the opposite direction. For example, if high tariffs lead to a sharp reduction in U.S. imports and tariff revenue falls short of expectations, it is not ruled out that there will be forced spending cuts. Second, whether the strong economic growth of the United States will enhance the sustainability of debt. One of the key conditions for measuring whether a country's debt is sustainable is whether economic growth can be higher than debt growth. We have calculated that from the second quarter of 2021 to the second quarter of 2024, the cumulative growth of U.S. quarterly nominal GDP was 24.2% (an annual compound growth of 7.5%), higher than the cumulative growth of the total amount of U.S. outstanding debt during the same period, which was 22.1% (an annual compound growth of 6.9%). This indicates that at least in the past three years, U.S. economic growth can fully digest the growth of debt. In addition, the latest calculations by CRFB show that stronger economic growth can help slow down the rate of increase in the debt ratio, thereby helping to improve the fiscal outlook [2]. In summary, whether the new U.S. government is forced to self-restraint on the fiscal path, or whether U.S. economic growth and debt growth remain basically matched, both may limit the intensification of U.S. debt risk, and the selling behavior related to the U.S. debt market may be excessive.