This analysis is by Bloomberg Intelligence Strategist Ira Jersey and Strategy Associate Will Hoffman. It appeared first on the Bloomberg Terminal.
Treasury yields could trade sideways over the next decade if our expectations are realized. The break of the four-decade downtrend in yields may not necessarily mean rates trend higher, though that’s possible. In this note, we show a possible wide long-term trading range, based on historical precedent.
Treasury yields to make decision on trend
With the four-decade downtrend in yields definitely broken, a new Treasury paradigm may be starting. Over the next decade (or more), we see two realistic possibilities. First, the market could begin a trend toward higher yields, as existed from the late 1950s until the early 1980s. However, this period was a historical anomaly (see next exhibit).
It’s more likely that 10-year Treasuries broadly trade within a 4% range bounded by 2% and 6%. Tight labor markets due to demographic trends and the stock of government debt may keep real yields higher than occurred in the inter-crisis period. Assuming typical business cycles return, the 10-year Treasury yield may sell off toward 6%, while rallying toward 2% as the Fed cuts interest rates. We assume the Fed isn’t again forced to lower rates below 1%.
Long term `normal’ rates between 2.25% and 6.3%
Monetary and market paradigms have shifted over many years, with increased market and regulatory sophistication, but long-term history has value for assessing the potential future of Treasury yields. We still think the high-interest-rate period in the decade starting 1975 may not be repeated. That high inflation, high interest-rate period was unique in the past 270 years of government bond trading.
For centuries, the British pound was the global reserve currency and related government debt was the benchmark interest rate. From the mid-1700s, excluding the 1970s oil-shock periods, the range for longer-term interest rates has been about 2.25% to 6.3%.
Sideways or reversal of trend?
We’re skeptical Treasuries will revert back to the longer-term downtrend in yields, with either a trend reversal or sideways market more likely outcomes. We think it most probable the market drops into a broad range for the next decade or more. Building a scenario using historical rate cycles starting in the early 1990s, the 10-year Treasury yield may rally to 2.51% in a recession, then sell off to multidecade highs well above 5%.
Yet a reversal of the four-decade trend isn’t out of the question. Deficits remaining high, real yields increasing if the labor market remains extremely tight, exogenous shocks (such as wars, oil spikes) and lower productivity could all contribute to higher yields over time. There will still be cyclical rate moves as business cycles turn, but in this scenario the overall yield trend is upward.
Yield fair value higher on paradigm shift
Not very much fundamental has changed in terms of how the market will price longer-term bond yields, but there are two very important shifts that some simple models aren’t catching. The first, which we’ve discussed previously (see link left) is debt dynamics. The much larger stock of debt today compared to decades past may keep yields higher than they otherwise would be — but yields aren’t cheap to fair value even given this shift. More relevant, in our view, is the propensity for the market to price for lower real yields than have existed historically.
The model is a multivariate linear regression with three independent variables on a quarterly basis back to 1953. The variables include the change in CPI, real GDP growth, and level of fed funds deflated by the three-month change in CPI.
Change in effective money leads inflation
Growth of our effective money measure (see methodology linked left) has slowed to 3.21% year-over-year as of the end of 2023. This is consistent with the year-over-year PCE deflator being at or below 2%. The Federal Reserve’s target being reached very near term may be improbable, but the slow growth of our measure of money suggests a reacceleration of inflation is unlikely without a shift in policy.
The Fed ending quantitative tightening (QT) doesn’t mean the pace of money growth will turn upward. The banking sector and government debt growth is actually stabilizing, so while effective money will continue to expand, the pace over the next several quarters should remain consistent.
