How high can interest rates go? – InsuranceNewsNet

By Lawrence Gillum

Inflationary dynamics continue to surprise on the upside, and markets now expect the Fed to continue one of its most aggressive rate hike campaigns in years. Yields on US Treasuries also continue to climb.

We believe we have seen the largest increases in yields, but as long as inflationary pressures continue to surprise on the upside, interest rate volatility is likely to persist. We still think the 10-year Treasury yield can end the year between 2.75% and 3.25%, but we recognize that there are upside risks.

Last week’s higher than expected inflation report was a game changer for the Federal Reserve (Fed) and bond markets. As inflationary pressures continue to be much higher than the Fed’s 2% target, an even more aggressive rate hike campaign has been priced into the markets.

Markets now expect at least a 75 basis point (bp) hike in its short-term interest rate at this week’s meeting and almost another 100 bp at the remaining two meetings this year. . Additionally, markets expect the fed funds rate to hit 4.5% early next year.

Due to ever-higher Fed rate hike expectations, the 10-year Treasury yield has risen nearly 200 basis points this year after rising about 100 basis points in 2020 and is at highest since 2011 [Figure 1]. The nearly 300 basis point upward move that has already taken place this cycle is the biggest upward move in yields since 1987, when rates rose 320 basis points.

Since the 1980s, the average rise from trough to peak in 10-year Treasury yields has been closer to 250 basis points, but that includes large rate increases in the early 1980s when US yields treasury bills were much higher. Since 2000, the average increase in the 10-year yield has been around 1.8%. We are clearly not in normal times, but the evolution of the 10-year Treasury yield since its low in August 2020 has been significant.

Could rates rise further? This will ultimately depend on the path of inflation. If inflation falls as we continue to expect, yields will likely fall as well. If inflation remains elevated and the Fed needs to be even more aggressive than currently expected, we could still see higher rates. However, as the Fed’s rate hikes trickle down to the real economy, the risk of a recession increases, which should help lower yields. As such, we still think the 10-year Treasury yield can end the year between 2.75% and 3.25%, but we recognize that there are upside risks.

Abnormal yield curve shape

The shape of the US Treasury yield curve is often considered a barometer of US economic growth. More specifically, it reflects how the Fed intends to stimulate or slow economic growth by reducing or increasing its key rate. In “normal” times, the yield curve slopes upward, which means that yields on longer-dated Treasury bills are higher than yields on shorter-dated Treasury bills. However, when the Fed wishes to slow growth to contain inflation, securities with shorter maturities could eventually outperform securities with longer maturities. This is called an inverted yield curve, which has been a fairly reliable predictor of economic recessions.

Over the past six months, the Fed has aggressively raised short-term interest rates in an effort to stop these continued increases in consumer prices and deliberately slow the economy. So when we look at the current yield curve [Figure 2]we see that the 2-year yield exceeds the 10-year Treasury yield and is therefore reversed.

But perhaps more worrying is that the 3M/10Y portion of the yield curve is also approaching inversion, a signal with more academic support. And as you can see in Figure 2, over the past several decades, economic recessions have occurred shortly after these yield curve inversions. Could this time be different?

Sure, but as the Fed continues to push short-term interest rates higher to slow the economy, recession risks will remain a concern for investors. While we don’t think a recession is likely this year, we think it’s roughly a 50/50 proposition in 2023. And as long as there are concerns about a slowing economy, we could see stable or lower long-term rates.

Quantitative tightening a joker

The Fed said it would like to get its balance sheet close to $9 trillion [Figure 3] back down to around 20% of US GDP (it’s currently closer to 40%), and as such it allows up to $95 billion of Treasury and mortgage-backed securities to flow organically out of its balance sheet as the bonds mature.

It should be noted that the Fed is not initially planning outright securities sales to reduce its balance sheet; on the contrary, it will only reduce the amount of reinvestments using monthly caps. In other words, the Fed will only let its balance sheet shrink gradually over time while paying attention to the impact QT has on the banking system.

So what happens to the money the Fed receives from principal repayments? Once Treasury bonds mature and the Treasury pays the Fed for those bonds, those funds are completely withdrawn from the financial system. Similarly to MBS, the Fed transacts in the secondary market, so once MBS mature naturally or through prepayments, the funds not reinvested are withdrawn from the financial system.

The purpose of QT is to withdraw liquidity from the financial system (primarily through banking channels) to tighten financial conditions, so that anything not reinvested by the Fed is completely removed. The Fed takes the product and just puts them out. Reserves disappear from the banking system in a few keystrokes as they appeared in a few keystrokes during QE.

Importantly, the impact on tightening financial conditions in this way is not well known. Remember, this only happened once. According to a study by the Atlanta Fed, a passive reduction of $2.2 trillion in the Fed’s balance sheet over three years would be equivalent to a 29 bp increase in the federal funds rate in normal times (when do things are still normal?) but 74 bp in times of crisis. So, alongside traditional rate hikes, QT is expected to tighten financial conditions with a few more rate hikes.

The unanswered question remains, however: how far can the Fed really go in reducing its balance sheet? The last time the Fed attempted to shrink its balance sheet, it was only able to withdraw about $750 billion of Treasuries and mortgage-backed securities before parts of the short-term funding markets, which are major corporate finance markets, are not under stress.

Existing liquidity in many government bond markets remains low, so the Fed will likely need to proceed with caution to ensure that the most important bond market, the Treasury market, remains fully functional. Given pockets of illiquidity in the Treasury market, we could see the yield spread widen if inflationary pressures continue to surprise markets.

Conclusion

The rise in yields we’ve seen this year has been painful for fixed income investors, period. What was once considered a conservative investment turned out to be anything but conservative this year. 2022 will go down as the worst year for bonds. Could yields increase from current levels? Much will depend on the path of inflationary pressures. If the Fed’s rate hikes start working and inflation starts falling, yields will likely fall as well. If inflationary pressures remain stubbornly high, we are likely to see higher yields as well.

If there’s a silver lining to rising yields this year, it’s that there are now many more opportunities in fixed income securities that can help investors achieve their income goals. In many markets, returns have not been this high for more than a decade. Bonds are unique in their structures in that coupon and principal payments are, for the most part, guaranteed and the primary drivers of long-term total returns.

The price volatility we have seen so far this year does not impact these payouts. It will certainly take time to recover from the declines fixed income investors have experienced this year, but with higher yields, fixed income is once again providing income.

Lawrence Gillum is a Fixed Income Strategist for LPL Financial

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