Long-term interest rates have been falling since the summer, most likely as investors came to terms with the risk of a slowing economy, domestic economic imbalances and the knock-on effects of persistent inflation.
While we expect the economy to reaccelerate next year on the back of tax cuts, lower rates, the full expensing of capital investment and revived M&A activity, the bond market is pushing yields down as if the economy is at risk.
So what gives?
Since the turn of the year, economic activity and financial markets have been driven by the large increase in infrastructure investment around artificial intelligence. Absent that robust investment, growth would be far slower or would have already slipped into contraction.
The bond market is pricing in something that in past cycles would have looked like a large midcycle slowdown or modest economic correction.
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Anything that alters that path of investment—which would dent equity markets and the portfolios of the upper spur of our K-shaped economy that is driving household consumption—would cause a significant slowdown in overall growth.
This is why despite moderate economic growth, we still maintain that there is a 40% chance of a recession over the next 12 months.
In the current cycle, the relationship between 10-year and 30-year Treasury yields has been altered, first with a bear-market selloff of 30-year bonds as the risk of fiscal malfeasance escalated.
Since June, 10-year yields have dropped by 51 basis points from 4.5% to 4.0% by the third week of October. During this same period, 30-year Treasury yields dropped by only 38 basis points, from roughly 5.0% to 4.6%.
We think there are several things at work here.
- Falling Treasury yields: Since June, both 10-year and 30-year Treasury yields have been dropping. This bull market implies an increased demand for longer-term securities coming at a time of reduced supply. Treasury issuance has turned to lower-yielding, short-term Treasury bills rather than more costly long-term notes and bonds. This comes at a time when market participants are expecting the Federal Reserve to maintain its holdings of long-term bonds
- Expected rate cuts: The forward market is now pricing in four federal funds rate cuts by next July. Because expectations for the federal funds rate have a greater impact on shorter-maturity bond yields, expectations of multiple rate cuts are pressuring 10-year bond yields lower at a faster rate than 30-year bonds.
- Concerns over growth: There is increased apprehension regarding a slowing economy and lower inflation. The labor market is signaling slowing demand for labor, which translates into lower household income, a drop in consumption and therefore lower prices, subdued inflation and lower interest rates. This slowing demand comes despite the onset of full expensing of capital investments and upcoming tax cuts.
- Lofty equity valuations: There is concern of a stock market bubble. That implies increased safe-haven demand for Treasury securities and therefore lower bond yields.
- The term premium is falling again: The term premium component of bond yields compensates investors for the risk of changes in monetary policy over the life of the bond. A negative term premium implies the risk of a faltering economy and deflation.
