Treasury yields are primarily driven by expectations for the future path of Federal Reserve monetary policy. This relationship is especially strong at the front end of the yield curve, where yields are closely linked to expectations about how the Fed will adjust interest rates over the near-term. However, monetary policy expectations remain important even at the long end of the curve. The difference is that longer-term yields are also more sensitive to changes in the economic outlook, inflation expectations and the compensation investors demand for holding long-duration bonds, called term premium.
The front-end is driven by monetary policy expectations
The 2-year Treasury yield is one of the most useful indicators of market expectations for Federal Reserve policy. If markets begin to expect the Fed to raise interest rates in the coming months, the two-year yield will generally rise. Conversely, if economic data weakens or inflation moderates, markets will start to price in rate cuts and the 2-year yield will generally fall.
The key point is that markets are forward-looking. Treasury yields reflect expectations for future short-term interest rates over the life of the bond. Consequently, yields will move well before the Fed actually changes its policy rate. That doesn’t mean the market will always be right. Sometimes the market gets things wrong, but the change in expectations still drives yields higher or lower depending on the economic context and incoming information.
The long-end is still driven by monetary policy expectations
The 10-year and 30-year Treasury yields are often framed as though they move independently of the Fed. But that’s misleading. Expectations for monetary policy remain a fundamental driver of longer-term yields, but their influence is more complex because investors must consider a much longer economic horizon.
A longer-term Treasury yield can be decomposed into two components: expected future short-term interest rates and a term premium. The first component links long-term yields directly to monetary policy expectations. If investors expect the Fed to maintain restrictive policy for longer, or believe that short-term rates will settle at a higher level over the coming decade, longer-term yields will generally face upward pressure.
The second component helps explain why long-term yields can move significantly even when expectations for the federal funds rate change very little. The term premium can rise when uncertainty about inflation increases for example, as investors will demand greater compensation for bearing duration risk. Changes in the supply and demand for Treasuries can also influence this premium, although it’s a very minor part. The term premium is not seomthing that is observable or can be accurately calculated. It changes based on the economic context.
Chart: Federal Funds Rate (black), 2y yield (red), 5y yield (green), 10y yield (violet), 30y yield (blue)
Long-term yields are more sensitive to growth and inflation
Although monetary policy expectations matter across the entire yield curve, the further we move out in maturity, the more economic developments can influence the outlook for interest rates over the longer run.
Suppose we get a very strong US PMI report that changes expectations about growth. The data might lead markets to expect more Fed rate hikes, pushing the 2-year yield higher, but the implications for the 10-year yield can extend beyond the next few Fed meetings. Stronger growth could imply a higher equilibrium real interest rate, stronger underlying demand and potentially greater inflationary pressure. If investors think that the economy can sustain higher interest rates over the long run, long-term yields may rise by more than the 2-year yield.
This is what generally leads to a bear steepening of the curve as long-term bonds fall faster than short-term bonds. That’s exactly what happened after the September’s US Flash PMI, as you can see in the chart below.
The same logic applies to inflation. A temporary increase in inflation might change expectations for the next few Fed meetings, but a persistent inflation shock can alter expectations for inflation over many years. Investors may also demand a higher term premium because of increased uncertainty.
The reverse is also true. A deterioration in the growth outlook can push yields lower as markets anticipate monetary easing. This is why before an economic slowdown or even a recession, the 10-year yield falls faster than the 2-year yield. This can happen even during a Federal Reserve tightening cycle if the markets think that the central bank overtightened and will have to cut interest rates sooner than expected.
This is why longer-term yields can experience larger swings than shorter-term yields. They reflect not only the expected response of monetary policy in the near-term but also changing views about the economy over a longer horizon.
This article was written by Giuseppe Dellamotta at investinglive.com.
