Since the future is uncertain, bond investors usually demand higher yields for longer duration. This is called a “term premium.” It results in a normal, positive-sloped yield curve.
The yield curve flattened as the Federal Reserve raised the fed funds rate, beginning in late 2022. The yield curve inverted (shorter durations yielded more than longer durations) at the start of 2023. It has been inverted ever since. To see how the shape of the yield curve changes over time, slide the vertical red line to the left in this chart.
For the past few weeks, bond investors have demanded higher yields for longer durations, causing the yield curve to flatten. This is a more normal situation when investors want a term premium.
The charts below show how longer term Treasury yields are rising fast, despite flight-to-safety buying due to the terrorist invasion of Israel which could spread into a regional war.
The 10-year Treasury yield, which impacts many other credit products, is the highest since 2007.
Higher Bond Yields Likely to Extend Fed Rate Pause
Officials are signaling that a run-up in long-term interest rates might substitute for a further central bank rate hike
By Nick Timiraos, The Wall Street Journal, Updated Oct. 10, 2023
A sustained rise in long-term Treasury yields could be bringing the Federal Reserve’s historic rate hiking cycle to an anticlimactic end.
Top central bank officials have signaled in recent days that they could be done raising short-term interest rates if long-term rates remain near their recent highs and inflation continues to cool… Higher borrowing costs lead to weaker investment and spending, a dynamic that is reinforced when higher rates also weigh on stocks and other asset prices…
Asset managers say the rise in term premiums in recent weeks has been driven by investors grappling with higher-than-anticipated government-debt issuance to finance larger U.S. deficits. A shift now toward higher term premiums would mark an abrupt reversal following the low-inflation, low-growth environment that prevailed between the 2008-09 financial crisis and the pandemic…[end quote]
There’s no indication that high government debt issuance will abate. If the Fed does not resume its purchase of government debt (which it only used in emergencies like the financial and Covid crises) the bond market will price the bonds according to supply and demand. Rising supply will force prices down, increasing yields.
If a return to (historically normal) higher term premiums persist, it would be a significant trend change. METARs should pay attention since the price of all assets would fall as a result.
Wendy