Market Extra: Rising Treasury yields are upsetting financial markets. Here’s why.

Rising long-term Treasury yields are generally the bond market’s way of signaling a brighter economic outlook ahead. However, this time around, there’s a bit more going on, strategists said. The climb in yields also reflects investors’ demand for more compensation to hold Treasurys to maturity, given all the uncertainties that could emerge over the life of those securities, strategists said.

The continued bond-market selloff burned existing holders of government debt and deepened the stock-market selloff. The Dow Jones Industrial Average
DJIA
wiped out its 2023 gain on Tuesday as yields climbed, and the S&P 500
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ended at its lowest since June.

The move toward 5% in the 10- and 30-year yields “probably had to happen at some point,” said Lawrence Gillum, a Charlotte, North Carolina-based fixed-income strategist for broker-dealer LPL Financial. “We can’t stay at zero interest-rate policy forever. But the speed and levels at which it has taken place corresponds with something breaking, whether it’s in housing or it’s consumers. Whether it’s mortgage rates, consumer rates, or auto loans, the cost of borrowing is getting really expensive.”

Here are some of the biggest reasons behind the current run-up in long-term market-implied rates:

Higher term premium

Term premium or premia is a phrase that matters a lot in the bond market, but is fuzzy to quantify. It refers to the compensation that investors require for the risk of holding a Treasury to maturity. It’s been negative for years and just recently turned positive.

A perfect storm for selloffs has been brewing due to growing risks that have emerged during the current era of inflation. Those risks range from a greater-than-expected U.S. budget deficit and the Treasury’s need to issue more supply to an unexpectedly strong U.S. economy that may require more tightening by the Federal Reserve. In addition, interest rates are expected to stay high for a prolonged period.

Last week, Alex Pelle, an economist at Mizuho Securities in New York, described the market’s recalculation of term premium as one of the biggest factors sending long-term Treasury yields to multiyear highs. And those rates have only continued to climb ever since.

See also: Entire U.S. Treasury yield curve moves toward or above 5%, raising risk something may break

“For the time being, there is no compelling incentive to assume rates don’t have further capacity to rise in the current environment,” said BMO Capital Markets strategists Ian Lyngen and Ben Jeffery. “The most obvious inhibition toward higher yields at this stage would be evidence that other financial markets are unable to withstand an elevated rates regime.”

Accordingly, “investors have been anxiously monitoring the performance of risk assets and despite a pullback from the highs, the perception remains that equities have held in well — all things considered,” Lyngen and Jeffery said in a note released before the stock market opened on Tuesday.

Economic strength

Another big reason for the recent run-up in yields is the surprising strength of the U.S. economy, as demonstrated by Tuesday’s data.

Job openings jumped to 9.6 million in August — defying expectations for the labor market to buckle under the pressure of more than five full percentage points of Fed rate hikes since March 2022. That hasn’t happened yet.

There’s more jobs-related data on the way this week, with the marquee event being Friday’s nonfarm payrolls report for September. Economists polled by The Wall Street Journal expect the report to show 170,000 jobs added last month, down from 187,000 in August.

“We’ve had jobs openings top all forecasts and hit the highest level since May of this year. The labor market is still adding jobs on a monthly basis,” said economist Lauren Henderson at Stifel, Nicolaus & Co. in Chicago. “We’re seeing a tight labor market and inflation coming down from its peaks. Investors are seeing an economic outlook that might be somewhat brighter than expected.”

However, “that also gives the Fed reason to hike at least one more time this year,” she said via phone. “We don’t think this is a sustainable run-up in yields. We are calling for some downturn to growth in 2024, whether it’s from a recession or just a slowdown.”

Tighter Fed

Continued economic resilience likely means that the Fed needs to keep tightening, which is also adding to upward pressure on yields. On Tuesday, rates on everything from 3-month Treasury bills
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through 30-year bonds either inched further above or toward 5%. The Fed’s main interest-rate target currently sits between 5.25%-5.5%, with some risk that it could go to 5.5%-5.75% by December.

Despite the highest interest rates in 22 years, the bond market is in the process of unwinding its earlier call for an economic downturn through an un-inverting yield curve. That simply means that long-term yields are finally catching up to where shorter-term rates are trading, and producing either a less negative or positive spread between the two.

The spread between 2- and 10-year yields, for example, shrunk to as little as minus 34.7 basis points on Tuesday — steepening from the triple-digit negative levels seen in March and June-July.

“The yield curve was deeply inverted because of expectations for a recession, and we’re seeing this unwind,” said Gillum of LPL Financial. “The speed with which markets have repriced, producing big moves in 10- and 30-year yields, impacts things like equities.

“If the economic data continues to signal a recession isn’t a fourth or first quarter event, we could see the yield curve completely un-invert and the 10-year rate around 5.25% or 5.5%, depending on data,” he said. “The markets are moving pretty quickly, so it’s complete doable for the 30-year yield to break above 5% if Friday’s nonfarm payrolls data comes in ‘hot.’”