September 2023 saw a sudden rise in Treasury yields, especially at the longer end, despite the Federal Reserve holding the short-term fed funds rate constant. Moderate to longer term Treasury yields have a strong impact on consumer and business borrowing rates.
The increase is a real (inflation adjusted) increase, as shown by the spike in TIPS yields. The 10-Year Expected Inflation rate is only 2.2%.
Before 2008, long-term bond yields were set by supply and demand in the market. If bond traders anticipated inflation or excess debt issuance, they would demand higher yields to compensate. “Bond Vigilantes” pressured the government to control inflation because otherwise they would charge the government higher interest to lend.
Starting in 2008, the Federal Reserve repressed long-term yields by buying immense amounts of Treasury and mortgage debt (“Quantitative Easing”). The Fed trumped the bond vigilantes, forcing yields lower until the real yields were negative. But the Fed began to back out of the bond market in 2022, gradually allowing its bond holdings to roll off when they matured (“Quantitative Tightening”). Now the traditional market forces setting the price of borrowing have more power.
Have the bond vigilantes returned to push up real yields? Forecast future government deficits are immense so it would make sense to demand higher real future yields.
The Fed has declared that, once inflation is under control, it wants to return to a neutral monetary regime – one that neither stimulates nor slows the economy. For economic calculations, this is called r* (“r-star”). r-star is defined as “the real short-term interest rate expected to prevail when an economy is at full strength and inflation is stable.”
Different Fed analysts disagree on r*.
This is the short-term fed funds rate. It does not account for fiscal stimulus changes from government spending or the long-term yields set by the market.
How long will real Treasury yields remain at their current level? Will they continue to rise? Paul Krugman, as usual, is an optimist and believes that both elevated inflation and high real yields are transitory. But even he is uncertain. The WSJ points out that rising Treasury yields are a strain on the U.S. budget. But cutting the deficit is next to impossible.
Treasury prices are currently in “falling knife” mode since bond prices move opposite their yields. How long will this go on? Even the pros don’t know. Meanwhile, TIPS yields are the highest they have been since 2008. It might be worthwhile to cash in the I-Bonds bought in 2020-2021 and buy TIPS. (This will sacrifice 3 months of interest.)