Has the 10-Year Treasury Yield Peaked?

Winkelmann

Inflation and Recession The Fed Central Bank Policy Trends Economic Trends

Summary:

As inflation is slowing down, markets expect that the Fed will decelerate the pace of rate hikes. In particular, the constant inversion of the yield curve indicates that the Fed's tightening policy is entering the final stage and the US Treasury yields may have peaked.

Perhaps the yield curve is the most striking aspect of the Fed's tightening cycle. The key yield curve, which measures the difference between 2-year and 10-year Treasury yields, has been inverted for a long time, which commonly indicates an impending recession. As the Fed's tightening policy is approaching its limit, the time to pause or cut interest rates is getting closer. Is this a prelude to the top of long-term interest rates?

Inflation Has Peaked

Actually, according to recent statistics, energy prices have been sinking due to the relaxation of supply chain tensions and the strike to the demand by the risk of a global recession. Inflation in the United States has shifted the dominance from energy to services, with the largest proportion of which accounts for housing. As we can see, continued rate hikes of the Fed have hit the housing market hard. While mortgage costs are still above 6%. Home sales and new construction have decelerated sharply over the past year. And home prices have also dropped down month-on-month. However, housing rents, as a major driver of the US CPI, have not yet established a downward trend.

Has the 10-Year Treasury Yield Peaked? _2

According to historical law, that house prices in the United States tend to be half a year to one year ahead of rents, the national house price index has begun to decline since April this year. Housing rents will most likely hit the top at the end of this year or early 2023. Even on a high base, the year-on-year growth rate in 2023 will decline gradually. And the inflection point for core inflation will also truly arrive. Taken together, this round of inflation is stepping to an end.

The Inflection Point of Rate Hikes Is Getting Closer

Nowadays, inflation has seen signs of life, which will extend its moderation considerably in the future. Despite the job market is still dynamic, it can mainly attribute to the lagging nature of the monetary policy. As the Fed continued to raise rates, costs of borrowing also have climbed incessantly, which is bound to suppress people's enthusiasm for consumption and investment. Therefore, it is inevitable that the unemployment rate will rise and the demand will shrink in the future. It is what the Fed will have to sacrifice in order to fight inflation.

For the time being, the market estimates the Fed will decelerate the rate hiking to 50 BPs at the December meeting. The hawkish stance of the Fed is eager to its peak. However, the Fed also avoids seeing expectations about overly optimistic markets and renewed easing financial conditions, which could undermine efforts to fight inflation. Therefore, the Fed should avoid not only the risk of a recession exacerbated by immoderate tightenings but also an excessive shift in monetary policy. According to the current statements of Fed officials and market expectations, the better strategy in the future is to release some hawkish signals to dampen market enthusiasm and maintain the rate level for a period of time after raising the rate to a bit higher than 5%.

Has the 10-Year Treasury Yield Peaked? _3

Source: CME FedWatch Tool

With the cooling off in inflation and the job market next year, strategies for the Fed to raise rates will probably be as follow: After a 50bps hike in December, there could be a further slowdown in January and March, with two 25bps hikes separately. At that time, the policy rate will fluctuate in the range of 4.75-5.0, around the expected 5%. So far, it is one step closer to the suspension of interest rate hikes. To make a bold guess, it can already be fully prepared for the final end of the interest rate hike in the first half of next year.

The 10-Year Treasury Yield Could Peak

Since November, the 10-year Treasury yield has fallen significantly, while the short- and medium-term yields were not the same, which has led to a deepening of the US yield curve inversion. It can also be interpreted as the first peak in the 10-year US Treasury rate.

Has the 10-Year Treasury Yield Peaked? _4

Historically, the downward revision of forward policy rate expectations has been the major reason for the decline of the 10-year U.S. Treasury rate in the later stages of the rate hike. Even if the rate hike has not stopped, the US Treasury rate will also decline sharply in line with expectations. In other words, the more interest rates are raised now, the more room for the future to decline and the possibilities will be greater as well. Since short- and medium-term Treasury yields are very sensitive to interest rates, they may keep climbing in the future with the policy rate. However, the Fed's continued rate hikes will strengthen expectations of the forward rate cut but are limited to the impetus of long-term U.S. Treasury rates. Therefore, the risk that the 10-year U.S. Treasury rate will break through the previous high is low.

However, problems with the debt ceiling of the United States should also be noted. In particular, the Republican Party of the US has controlled the House of Representatives. The split in Congress could stunt the rise to the debt ceiling, which will in turn increase the risk of default on US bonds and causes a surge of US bond yields in the short term. Of course, in the longer term, after the end of this round of interest rate hikes, the 10-year U.S. Treasury yield will also be affected by the expectation of interest rate cuts, which contains further downside risks.

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