After four decades of trend decline, 10-year US Treasury yields have moved up to levels last seen in the 2000s (see Chart 1). Some of the rise in long-term yields is due to Fed tightening, but we argue that other yield drivers have changed as well.
Source: Board of Governors of the Federal Reserve1
As a result, we think yields are unlikely to fall anywhere near the levels of the 2010s even if and when the Fed starts to cut interest rates.
In this paper, we show that not only the Fed but also the balance of savings and investment in the economy, as well as growth and inflation fundamentals, are key for determining the level of long-term yields.
On the other hand, the economy is not sick, and we believe that improving global growth conditions will support growth in the US as well. We also observe promising signs of structural change that may raise US productivity over time.
Since the 1980s, most of these forces have put downward pressure on yields. Going forward, we think several forces will put lasting upward pressure on yields.
In our base scenario, we estimate that macro and policy trends over the next 5 to 10 year business cycle will be consistent with a 10-year Treasury yield of around 4%. The risk is that higher macro and policy volatility pushes the 10-year Treasury yield to 6%.
In any case, we expect higher yields for longer and believe financial markets and the economy still have some adjustment ahead. This may not lead to a crisis but will make the going tougher, especially for weaker credits and the government.
We start our analysis by dividing nominal yields into real yields and inflation expectations. This can be done in two ways, subtracting either survey-based 10-year inflation expectations or 10-year inflation adjusted yields from nominal 10-year yields. The implied real yields are fairly similar but the survey-based real yield has a much longer track record which is important for our analysis (see Chart 2).
Source: Board of Governors of the Federal Reserve & Federal Reserve Bank of Philadelphia.2
As seen in Chart 2, real yields are volatile but there are also clear trends. Most notable is the trend decline in real yields from around 8% in the early 1980s to about zero in the decade after the great financial crisis (GFC). Survey-based inflation expectations followed a similar pattern, but are less volatile and had already stabilized in the early 2000s (see Chart 3).
Source: Federal Reserve Bank of Philadelphia.3
Overall, nominal 10-year Treasury yields fell from around 14% in the early 1980s to about 2.5% in the decade after the GFC.4 Of that, roughly 60% can be attributed to the decline in real yields and 40% is due to the decline in inflation expectations.5 The recent rise in nominal yields, however, appears mostly due to a jump in real yields to about 2%.6 Inflation expectations increased temporarily, but are back to the pre-COVID level.7
In our view, inflation expectations are both adaptive and rational, i.e., shaped by people’s actual inflation experience as well as their assessment of the inflationary implications of monetary policy and major economic and political developments.
We interpret, thus, the recent decline of inflation expectations as a function of the actual disinflation process that started in mid 2022,8 as well as a sign of people’s confidence that the Fed will push inflation towards 2%.
Before we continue on the outlook for inflation expectations, however, we first take a closer look at the drivers of real yields. In our framework, we view real yields as determined by three main categories.
Table 1 shows the average real yield over the last four decades as well as the last three quarters, plus the values of the components outlined above and our estimations of their contributions to real yields. These estimated contributions are based on our regression analysis, which explains about 95% of the average real yield changes over the last four decades and confirms our views about the directional impact of each variable on real yields, as outlined in our assumptions above. Our following four observations are all based on the figures outlined in Table 1.
* 2023H2 & 2024Q1; ** Variable value; *** % pts contribution of the variable to the real yield level.
Source: See detailed source descriptions and outline of the regression analysis in footnote 99
First, falling potential growth and inflation-risk premium have been powerful drivers of the decline in real yields over the last four decades, lowering real yields together by nearly two percentage points.
Second, there have been large swings in the flow of funds but their aggregated impact pushed real yields only slightly lower over the last four decades. Government net savings improved in the 1990s and 2000s but slipped massively in the 2010s. Private net savings fell until the 2010s but then rebounded strongly in the 2010s.
We see a negative correlation between government and private net savings (i.e., private net savings rise when government net savings decline), which gives some validity to the Ricardian Equivalence Theorem and the Crowding Out Effect, but their respective degrees change over time, suggesting that other factors are at work, as well.10
Foreign net lending increased sharply in the 2000s when reserve accumulation by foreign countries, especially in Asia, was running hot, but moderated in the 2010s.11 The rise in foreign net lending in the 2000s more than offset the fall in private net savings and contributed significantly to the overall decline in real yields during that decade.
Third, monetary policy was the most powerful force in driving real yields lower over the last four decades. In the 2010s, monetary policy alone contributed nearly two percentage points to the decline in real yields, thanks in particular to the Fed’s quantitative policy measures. Without the Fed’s super-easy policy stance, real yields in the 2010s would have been close to the levels in the 2000s.
Of course, the Fed’s policy stance cannot be seen in isolation but should be viewed as a function of the broader macro trends, especially the decline in inflationary pressures. The use of quantitative policy measures was the Fed’s main tool to stimulate the flow of credit to the economy and maintain financial stability at a time when the Fed funds rate was at the effective (i.e., zero percent) lower boundary12
Fourth, the recent surge in real yields was driven in order of magnitude by the rise in the real Fed funds rate, the increase in the inflation risk premium and the decline in private net savings. What seems to have prevented an even further rise in real yields is the still very elevated level of Fed Treasury holdings stemming from earlier quantitative policy measures (especially during the COVID period, see Chart 413) and an increase in foreign net lending, which we attribute to the safe-haven appeal of the US in times of high geopolitical uncertainties.
Source: Board of Governors of the Federal Reserve and Bureau of Economic Analysis14
On the surface, current real yields are back to the levels last seen in the 2000s. Yet the composition is very different as seen in Table 1 and some components are unlikely to stay at current levels in the longer term. We also like to bring inflation expectations back into the equation to complete the outlook for nominal yields. We see five broad themes shaping real and nominal yields over the next cycle.
We expect government net savings (fiscal deficit) as a share of GDP to stay at the current level. In our view, there is neither political will nor public or financial market pressure to deal with the bloating deficit and the high and rising level of debt. The Congressional Budget Office even expects the deficit of the Federal government to rise further as a share of GDP, thanks to mounting mandatory and net interest outlays.15
In our view, a negative feedback loop is starting, as the government has to refinance maturing debt at higher interest rates which puts added upward pressure on the deficit and the interest on government debt. And this cycle spins faster the higher the debt-GDP ratio, which has already reached the 100% threshold.16
We expect private net savings to rise once the excess savings from the COVID period17 are exhausted, but not by much. Demographics is one factor that is likely to cap private net savings. The share of old people is growing rapidly, which means there are fewer people who can save, while increases in life expectancy have moderated, which implies for working-age people that the savings needed for retirement no longer have to rise as fast as they did in prior decades (see Chart 5).
*Life expectancy is calculated at the age of 15 and the old age share is the share of people 65 and older versus the working-age population (15-64).
Source: United Nations18
Similar to the government sector, we also see a negative feedback loop developing for interest expenses in the private sector. So far, the private sector benefitted from the low interest rates on the debt it locked in before the Fed started to hike interest rates.19 We expect that this effect will gradually fade and eventually turn in the opposite direction as more debt matures.
Another factor in our view is the increased investments needed to decarbonize the economy. This affects both the government and the private sector. There are good estimates of the investments needed to achieve the zero-emissions targets but we are not sure how soon and to what extent this objective will materialize.20 Still, we believe that climate-related investments will cause a bias to reduce both government and private net savings.
We believe the current high level of foreign net lending (inflows) is due to increased geopolitical uncertainties. In our base scenario, we assume that foreign net lending returns to the pre-COVID level of around 2% of GDP. The risk is clearly that global tensions will last much longer and lead to more safe-haven inflows. On the other hand, we believe the need for emerging economies to build more reserves is fading, while the pressure to diversify reserves into other currencies and asset markets is increasing.
We do not have a strong view on potential growth21 and think it will stay close to the current level, which is in line with estimates by the Congressional Budget Office and the Fed over the next 10 years, and within the broad range seen over the last 20 years.22
We are also confident that inflation will moderate further because we think the Fed will remain committed to inflation control. However, we do not expect a return to the low inflation environment of the 2010s.
In our view, labor market conditions will stay tighter thanks to demographics and the disinflationary forces stemming from the deleveraging dynamic following the GFC, as well as favorable global supply conditions (notably from Asia) are no longer in place.
Thus, while inflation had a bias to fall below 2% in 2010s, we think it will have a bias to push above 2% going forward and believe that this will be reflected in higher inflation expectations and risk premia than in the last two decades.
As stated before, we are convinced that the Fed will stay committed to inflation control, but while the Fed was trying to push inflation up towards 2% in the last decade, we think it has to make a bigger effort now to keep inflation from moving above 2%.23 To us, that means that the real Fed funds rate will have to be positive.
On the other hand, we think the Fed will continue its Ample Reserve Regime to control interest rates.24 That implies that the period of quantitative tightening (QT) will come to an end in the foreseeable future.25
It is even possible that the Fed at some point will start to buy securities again to keep reserves sufficiently ample. In other words, we believe the real-yield depressing effect of the quantitative policy measures is likely to prevail, although not at the peak levels seen during COVID.
As a result, we think the Fed will have to target a higher real Fed funds rate than its own projections currently imply, to neutralize at least parts of the stimulating impact of the prevailing quantitative policy measures.26
Table 2 shows our base scenario, which summarizes our five outlook themes, for real and nominal 10-year Treasury yields based on the framework outlined in Table 1 plus two alternative (low and high yield) scenarios.
* 5-to-10 year horizon or business cycle average; ** Variable value; *** Contribution of the variable to the real yield level.
Source: Same as Table 1 and ZAIS’s own scenario projections.
The base scenario projects that the nominal 10-year Treasury yield should average around 4% for the next 5 to 10 years, which is close to current levels, even though we do expect some Fed easing. Compared to the 2010s, we anticipate upward pressure from most components. However, our estimates suggest that yields would be significantly higher if the Fed were to unwind all its Treasuries holdings from earlier quantitative policy measures.
In the “low” yield scenario, real and nominal yields fall back to the levels last seen in the 2010s. That requires improvements on all scores. Most importantly, inflationary pressures have to decrease much further to allow the Fed to cut the real Fed funds rate sharply and keep the quantitative policy measures at the current level. Such a scenario cannot be ruled out but we assign it a low probability, given our view on the change in underlying inflation dynamics.
Instead, we think risks are biased to the upside, especially if underlying inflation pressures become entrenched and the Fed has to maintain a tighter policy stance. This situation could worsen further if the balance of the flow of funds deteriorates as well. We estimate that the 10-year Treasury yield could exceed 6% under these conditions.
As outlined in the previous ZAIS Insight “Resilient but not Invincible”, a large share of the outstanding debt in the economy is still based on interest rate terms set before the Fed started to tighten policy.27 If our yield outlook is right, overall interest payments in the economy will rise as maturing debt is refinanced and new debt comes to the market.
In our view, that may not lead to a crisis, but it would be a fundamental change from an environment in which interest rate conditions provided powerful tailwinds to a state in which interest rate conditions become at least moderately restrictive.
We think the household sector is best placed to handle the adjustment and the government will feel the pinch the most, while the business sector falls somewhere in between. Importantly, we anticipate more bifurcation between strong and weak credits.
Our positive view on the household sector reflects the post-GFC deleveraging and the robust labor-market and income conditions.28 We think this will keep debt-service payments on existing mortgages at a manageable level even as effective interest rates gradually rise (see Chart 6).
Homebuyers, however, will probably struggle if mortgage rates stay higher for longer, which means that housing construction is unlikely to become a powerful engine of growth.29
In contrast to mortgages, there are clear signs of distress in credit card loans and, to a lesser extent, auto loans (see Chart 7).
Source: Board of Governors of the Federal Reserve30
Source: Federal Reserve Bank of New York31
We see this as a reflection of three factors: weaker debtor fundamentals,32 shorter term structures (credit card loan interest rates are variable) and, in the case of credit card loans, a much larger increase in interest rates.33
As we argued in the ZAIS Insight “Diverging Household Health” last year, adverse financial conditions impact lower-income households more than wealthy ones34 Thus, we see some further upside risk to credit card and auto loan delinquency rates. However, credit card and auto loans account for a much smaller share of overall household debt and are, thus, unlikely to create systemic stress.35
We are not expecting higher for longer to create an overall systemic problem in the business sector either, but we think the adjustment process will be more volatile and create more individual distress situations compared with the household sector.
We see four factors that make the business sector somewhat more vulnerable to higher for longer than the household sector: first, less effort to restrain leverage since the GFC36; second, shorter debt maturities, especially compared to household mortgages; third, more varied credit fundamentals; and fourth, idiosyncratic challenges.
A leading example is the leveraged loan sector, given its floating-rate nature. Last year, we predicted that the leveraged loan default rate would rise to at least 4% within 18 months.37 Currently, the leveraged loan default rate is around 2% but when combined with distressed exchanges, which have become a popular way of resolving distress situations to avoid outright default, the total has climbed to 4.3% (see Chart 8).
Source: Pitchbook LCD38
The share of leveraged loan issuers with low interest coverage ratios of two or less has declined lately, which suggests to us that the worst of the adjustment in leveraged loans to higher interest rates is probably over (see Chart 9). However, we see continued risks from private companies which make up a high share of leveraged loan issuers with interest rate coverage ratios of two or less.39
Source: JPMorgan40
We believe the high-yield bond market still has to go through some of the adjustment already seen in the leveraged loan market as debt matures, but less so given its better credit fundamentals.41 Leverage ratios in high yield bonds are about a quarter lower than in leveraged loans (see Chart 10).
Further, interest coverage ratios in high yield bonds are twice as high as in leveraged loans.42 We expect interest coverage ratios in high yield to decline but less so and from a higher starting level, compared to leveraged loans.43
Source: JPMorgan44
The challenges created by the rise of working-from-home for the office sector present a special case. In a prior ZAIS Insight “Dipping a Toe Back into CMBS” we pointed out that higher interest rates and tighter lending standards raised the hurdle for debt refinancing of commercial real estate.45
Source: Trepp46
We argued that many office properties struggle to generate sufficient net operating income growth to refinance their maturing debt, given the particular challenges in the sector. The result has been a surge in office CMBS delinquencies compared to other property types, which we believe has still some way to go, due to the dispersion in office qualities and credit fundamentals (see Chart 11).
The consequences of higher for longer for the government are well outlined in the latest outlook of the Congressional Budget Office (CBO)47. The CBO assumes an average 10-year Treasury yield of around 4% until 2034, similar to our base-case scenario.
As a result, the CBO expects interest outlays to rise from 2.4% of GDP in 2023 to nearly 4% of GDP by 2034, well above the previous highs when the effective interest rate paid on federal debt was more than double what the CBO forecasts for the next 10 years (see Chart 12).
Source: Office of Management and Budget, Congressional Budget Office and Federal Reserve Bank of St. Louis48
The difference is explained by the much higher debt-to-GDP ratio now, compared to 40 years ago (see Chart 13). The CBO expects this dynamic to continue over the next 30 years with interest outlays reaching 6.4% of GDP and the debt/GDP ratio climbing to 166% by 205449
Source: Office of Management and Budget, Congressional Budget Office and Federal Reserve Bank of St. Louis50
If and when such a dynamic could lead to a crisis is hard to judge and depends also on other factors, such as the financial and regulatory structure, the flow of funds inside the economy and with the rest of the world, the reserve currency status and the ability of the central bank to monetize the debt without creating run-away inflation. Japan, for example, has not yet experienced a crisis despite the government debt/GDP ratio rising from less than 50% in 1980 to over 250% now.51
On the other hand, the ingredients for a potential government debt crisis are there. Turning a blind eye on the sustainability problems of government debt and hoping that Japan’s experience will apply to the US or that economic growth will rise materially while interest rates will decline significantly would be a mistake, in our view.
Eliminating the risk of a crisis means adjusting taxes and non-interest outlays in such a way that it stabilizes the debt-to-GDP ratio. The IMF estimates that the US government would have to improve its primary fiscal balance (excluding interest outlays) by 4% points of GDP over the next five years in order to stabilize this ratio by 2029.52
We cannot know whether and when policy makers will respond to this risk and take action. It is difficult for politicians to reconcile election cycles and long-term debt sustainability objectives.
As a result, while we expect more credit and default-risk dispersion in the private sector, we think the systemic risk is with the government sector also, given its scale, concentration and binary risk profile.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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