For the past three years, our core macro theme has been that of regime change in the U.S. economy and financial markets.
That is, the economy will grow faster and require higher interest rates to compensate investors for the risk associated with holding long-term Treasury securities. This higher risk is being driven by government policy that carries an inflationary bias, more than had been the case during the era of globalization in previous decades.
Now, as populist economics takes hold and globalization fades, nowhere is the new regime better illustrated than in the widening U.S. 30-year less 10-year Treasury spread in the bond market.
The increase in that often-overlooked spread suggests that the economy is set to grow faster, generate higher inflation and demand a higher policy rate from the Federal Reserve as long-term interest rates rise.
Unfortunately, we tend to only look at this spread when the economy and financial markets are under stress and reach inflection points.
In addition, the move reflects a change in the perceptions of investors around the safe-haven value of holding long-dated U.S. paper. The Fed has curtailed purchases of long-run assets, capital inflows have slowed and higher inflation has dented the credibility of dollar-denominated assets.
What’s more, investors are growing increasingly concerned around the intersection of government spending, taxes, trade, inflation and growth.
These changes are removing the anchor around which investors allocate risk capital. And that requires higher rates and is the major catalyst behind the non-virtuous widening of that spread.
A quick look at the 30-year less 10-year spread provides some quick insights.
- First, the spread is back to pre-financial crisis levels. The average spread stands at 48 basis points, just below the long-term average of 51 after briefly inverting in 2023. That points to normalization in the relationship between financial markets and the economy following an extended period of unorthodox monetary policy that suppressed rates at the long end of the curve.
- Second, that normalization has not been well received by a generation of investors that grew accustomed to low interest rates. What makes it more challenging is the disruption caused by U.S. trade policy, which seeks to rebalance the global economy.
Selling at the long end of the curve has pushed both the 30-year and 10-year notes higher. This rise has taken place not for virtuous reasons around faster growth but rather because of risks around higher inflation and the need for higher interest rates to compensate for holding long-dated dollar-denominated assets.
The risks and opportunities around holding such debt are part of the explanation why the spread between the 30-year and 10-year yield is widening.
A structural change is taking place in the market, forcing a general repricing of risk.
Read more of RSM’s insights on the economy and the middle market.
It is important to note that the spread is sensitive to changes in inflation expectations and monetary policy, which are clearly in flux.
Under current conditions, the widening spread tells investors that they may not be adequately compensated for duration risk associated with holding long-dated financial instruments.
It is natural that information will in turn influence both pricing and hedging strategies around long-term debt, mortgages and pension liabilities.
