Treasury Market Comes Out of Denial, Grapples with “Higher-for-Longer,” QT, Flood of New Issuance. Long-Term Yields Jump

July 10, 2023

Denial works great until it doesn’t.

By Wolf Richter for WOLF STREET.

The 10-year yield closed at 4.06% on Friday, the highest since early March, when it went to 4.08%, at which point the Fed’s intervention to halt the bank-panic unleashed a massive rally in all kinds of assets, including longer-term bonds, on the fervent hopes that this would be the beginning of QE all over again. It knocked the 10-year yield back down to the 3.3% range. But that rally in longer-term bonds has been replaced by a selloff, and yields have shot higher.

The last time before this rate-hike cycle that we saw a 10-year yield of 4.06% was during the Financial Crisis in 2008, when it was on the way down.

Over the three months from early August through early November last year, the 10-year yield spiked by a lightning-fast 1.6 percentage points from 2.6% to 4.2%, as bond prices plunged. This was followed by a rally in prices (yields fell again) – logical after that kind of move. And then in February, yields worked their way higher again until mid-March, when the Fed’s reaction spawned fervent hopes for QE, prices took off, and yields fell again.

But the bond market rally fizzled as it became clear that these QE hopes were in fact a fantasy, and that QT has in fact continued, despite the bank liquidity support measures: The Fed’s balance sheet has dropped below where it had been before the bank-panic bailout, to the lowest level since August 2021 (details here).

In addition, the market needs to absorb a huge amount of new issuance of Treasury securities, as the Treasury Department wants to refill its checking account, the Treasury General Account (TGA), and at the same time fund the ballooning deficits. So far, this additional issuance has been concentrated on short-term Treasury bills. But going forward, the Treasury Department is expected to increase the auction sizes of notes (2-10 years) and bonds (20 and 30 years). More supply coming on the market that needs to be absorbed, and higher yields will attract more buyers.

This flood of new longer-term notes and bonds is coming even as the Fed has stepped away from the Treasury market, has unloaded $665 billion in Treasuries from the peak in June 2022, and continues to shrink its Treasury holdings by about $60 billion a month. The Fed has already shed 20.5% of the Treasury securities it had bought under the pandemic QE.

So the longer-term Treasury market is beginning to come out of denial. It’s ever so gradually acknowledging that inflation is going to be higher for longer, and that interest rates are going to be higher for longer, and that some of these old assumptions about inflation and interest rates and pivots and QE are out the window.

Short-term Treasury market not in denial.

Short-term yields went haywire during the bank panic in March, and then again they went haywire during the Debt Ceiling fight. But they calmed down and dealt with the two rate hikes in March and May.

Now they’re confidently projecting two more rate hikes this year, having now gotten memo from the Fed’s FOMC meeting in June. The first hike, likely in July, is fully priced in, and the second one later this year is mostly priced in. Two rate hikes would take the Effective Federal Funds Rate (EFFR) from 5.08% now to about 5.58%.

The six-month yield closed on Friday at 5.53% and has been in this range for four days. Securities with a remaining maturity of six months mature by the end of this year, and that is the extent of what concerns them. They’re not in denial of anything, they’re on target:

The one-year yield, which eyes events that would happen over the next 12 months, closed on Friday at 5.41%. It has been above 5.4% for six days in a row. It is now fully pricing in one rate hike and getting closer to pricing in another rate hike. And it’s not pricing in a rate cut over the next 12 months, which makes sense, and there is no denial of higher for longer within its 12-month window.