Long term bond rates are on the move, but this time, don't blame the Fed.
Between March 2022 and May 2023, the federal funds rate was increased at every FOMC meeting and climbed from 0% to 5%. The 10-year Treasury yield followed suit but to a significantly lesser extent, rising from 2.2% to 3.4%. This divergence resulted in a deeply inverted yield curve.
The Fed paused in June and hiked again in July, widely believed to be the final one in this tightening cycle. However, bond market dynamics have since changed. The shorter end of the yield curve has remained within a narrow 25 basis point range, while the longer end has started to soar.
The factors influencing long-term yields have indeed switched. Prior to 2022, the behavior of the 10-year yield was primarily driven by its term premium component, while the expected rate component remained relatively stable. Following the Federal Reserve's series of rate hikes, the expected rate component took precedence. A noticeable shift in this pattern has occurred since July: the expected rate component has stopped rising, and increases in the 10-year yield can be attributed entirely to changes in the term premium component.
The term premium is the compensation that investors demand for bearing the risk of potential interest rate changes during a bond's life. Unlike the expected rate, the term premium is predominantly determined by market participants rather than the Fed. Consequently, the reasons for its recent surge cannot be precisely pinpointed. Increases in inflation expectations, government spending, and economic growth could all push the term premium higher.
Higher long term rates are un-inverting the yield curve, but they spell trouble for investors. The dollar will strengthen, mortgage rates will rise, and financial conditions will become tighter. Above all, elevated rates and bond volatility disturb the delicate balance we've only recently begun to witness following the Fed's pause, introducing significant uncertainties at a time when investors are least inclined to embrace them.