The yields on U.S. 10-year Treasury have fallen to around 2.5 percent, which is almost 100 basis points lower than the 2022 peak. Since then, the Federal Reserve has raised rates by 150 basis points and the Fed fund rates are now between 2.25 percent and 2.50 percent. Why is the 10-year Treasury yield doing down despite the Fed’s rate hikes?
The Fed ended its tapering in the first quarter of 2022 and raised rates by 25 basis points in March, which was the first rate hike since 2018. It raised rates again by 50 basis points in May. This was followed by 75 basis point hikes in both June and July. Going by the June dot plot, the U.S. Central Bank intends to raise rates by 100 basis points more in 2022.
The Fed has embarked on an aggressive rate hike cycle.
Before 2021, the Fed hadn’t raised rates by 75 basis points since 1994. However, with inflation running above 9 percent, which is the highest since 1981, the Fed had to resort to unprecedented measures. Its language has also been getting hawkish and the Fed looks happy to sacrifice growth in order to tame inflation.
With the Fed raising rates and signaling another 75-basis point rate hike at the September meeting, one would have expected the yields on the 10-year Treasury to rise. However, the yields, which hit an 11-year high of 3.49 percent before the Fed’s June meeting, are now at around 2.55 percent.
The yields fell on both days of the Fed’s July meeting and have continued to slide since then. The benchmark bond fell on the first day of August as well. Why is the 10-year Treasury yield falling despite the Fed’s rate hikes?
Here’s why the 10-year Treasury yield is falling.
As old-timers would say, the bond markets are much more efficient than the stock markets. Generally, bonds price in the interest rate movements much before they happen. Now, there are multiple reasons why the 10-year Treasury is falling.
First, inflation expectations are coming down and prices should gradually come down over the next year. As inflation cools down, markets expect the Fed to take a more dovish view. Thanks to the Fed’s revised average inflation targeting approach, it won't wait for inflation to drop below 2 percent before changing course.
Second, the U.S. economy is cooling off quickly and has contracted in both the first and second quarters of 2022. While many would say the U.S. is already in a recession, the NBER’s (National Bureau of Economic Research) Business Cycle Dating Committee has a different mechanism to call a recession.
The Fed’s commentary on the economy, as well as the job market, is also turning incrementally bearish. Layoffs continue to mount in corporate America and Oracle has joined the long list of U.S. companies that are laying off employees.
Finally, investors are seeking solace in U.S. Treasury amid the economic turmoil. U.S. Treasury bonds are regarded as among the safest globally and in times of distress, many seek solace in the U.S. dollar and Treasury bonds.
The falling 10-year Treasury yield and inverted curve point to an impending recession.
The U.S. Treasury curve is inverted and the two-year yield is higher than the 10-year yield. This combined with the fall in 10-year Treasury bonds signals that markets expect a recession in the U.S. Also, markets seem to believe that the Fed will end its rate hikes soon and look at cutting rates to support the economic activity in the country.