There are growing signs that inflation is retreating while the labor market remains healthy.
Absent another shock, the Federal Reserve is likely to ease up on its rate increases as these dynamics take hold.
Even a pause in rate hikes would most likely guide the economy toward a mild downturn rather than an all-out recession.
Even as the economy shows positive trends like slowing inflation and a healthy labor market, the bond market is showing anxiety.
Such a scenario would set the stage for reduced volatility in bond yields and a greater willingness to borrow and to lend, leading to sustained growth.
For these reasons, we are keeping our year-end forecast on the 10-year yield at 3.8%, which is consistent with our view that the federal funds policy rate has peaked at 5% to 5.25%.
We also see the economy slowing from a 2.4% growth rate in the second quarter to 1.8% in the third, followed by a contraction of 1.1% in the fourth quarter and 0.6% the first quarter.
After that, we expect the expansion to continue near our long-term forecast of 1.8% yearly growth.
The decline in inflation that we expect should push real rates, or rates adjusted for inflation, higher using the Moody’s Baa investment grade corporate bond yield less the top-line consumer price index. That implies a 3% real yield.
This is critical, and middle market firms with exposure to financial markets should anticipate that as inflation declines further, real rates will continue to increase.
Yet this scenario—as benign as it is—could be derailed by another shock to the economy. And the bond markets are showing this anxiety.
On Aug. 1, Fitch Ratings, citing the political dysfunction over the debt ceiling, downgraded U.S. government securities. That move, in turn, prompted a selloff in equities and pushed 10-year bond yields above 4%.
In addition, the latest data from the banking sector reports a reluctance to borrow and lend in the first two quarters of the year—a reflection not only of the Fed’s aggressive interest rate increases but also of the shocks like the banking turmoil and debt ceiling standoff that took place this year.
Read more of RSM’s perspectives on the economy and the middle market.
The result has been a Treasury market that is still volatile as it prices in risks, both in the short term and long term.
In the short term, there is the potential of a government shutdown on Oct. 1 if Congress delays the yearly passage of the 13 appropriation bills. And there are the geopolitical threats to inflation from Saudi Arabia’s cutbacks in the oil market and the Russian blockade of grain shipments from Ukraine.
Finally, in the long term, there are the recent subtle shifts in Japan’s monetary policy that might affect the relative attractiveness of U.S. debt for one of its major purchasers.
In what follows, we’ll discuss the economic framework for market stability and then the caveats that threaten that benign view.
Expectations for inflation are dropping,…
… which reduces bond yields ,,,
Inflation expectations peaked last October and have since bounced with each shift in the prospects for a soft landing or a recession. Those shifts correspond with 10-year bond yields, which peaked last October at 4.05%, before trading between a low of 3.4% to barely touching 4.0% this year.
… even as volatility has persisted
While elevated inflation led to greater volatility in the bond market last year, more recent events like the banking turmoil, the debt-ceiling standoff and now the ratings downgrade have kept it going.
Where will 10-year yields settle?
The consensus of economists in the first week of August was for 10-year bond yields to drift down to 3.35% next year and then rise to 3.5% in 2025. Given the possibility of a mild recession, which would prompt the Fed to reduce its policy rate, our expectations are for 10-year yields to move as low as 3.0% in 2025.
In the past two business cycles, the range of long-term interest rates has been dictated by the response to inflation pressures from 2002 to 2006 and then by disinflation and the threat of deflation from 2010 to the pandemic.
In this current period, with the labor shortages and higher wages for low-wage jobs, we expect the economy and inflation to occupy a middle ground.
Assuming a de facto 3% inflation target, a reduced federal funds rate and moderate economic growth, we see 10-year yields trading in the 3% to 4% range.
Many factors, though, could derail this scenario.
The inverted yield curve
The bond market is hedging the consensus bet on a soft landing.
Normally, longer-term interest rates are higher than short-term interest rates. But with the Fed pushing short-rates higher to increase the cost of credit and to crimp investment and spending, the yield curve has become inverted, sloping downward instead of upward.
The higher cost of credit and capital leads to less borrowing, spending and investment and, ultimately, reduced economic activity. A yield-curve inversion has correctly predicted a recession over the past seven decades.
Today, the yield curve has not been this inverted since the double-dip recessions of the early 1980s, leading the New York Fed at the end of July to give a 67% probability of a recession over the next 12 months.
The cost of political dysfunction
Longstanding rules in Congress require lawmakers to raise the nation’s debt limit from time to time and to pass yearly appropriation measures.
Political brinkmanship over these measures has led to government shutdowns in recent years, and markets have taken notice. In response to the debt-ceiling standoff in 2011, Standard and Poor’s cut its ratings of Treasury bonds from AAA, its highest, to AA+. The stock market lost nearly 18% of its value.
Then came Fitch Ratings’ downgrade in August, which prompted a 2% drop in the S&P 500 index and an increase in Treasury yields to as high as 4.2%.
The brinkmanship cannot go on forever. The financial system will at some point become too fragile.
Russia’s war on food
Russia is now blocking grain shipments out of Ukraine. Like energy, food is priced within a global market, with ramifications from Africa to U.S. grocery stores. A decrease in the supply of food will affect all economies, just as a decrease in the supply of oil engineered by Saudi Arabia will hit energy markets.
Japan’s appetite for U.S. debt
Foreign investors have long supported U.S. government securities, attracted by their safety and returns. In recent years, Japan has had a healthy demand for Treasury bonds, bolstered by the Bank of Japan’s yield curve control policy and the issuance of Japanese government bonds at near-zero and then negative interest rates.
Now, with Japan’s inflation finally increasing, the Bank of Japan appears to have taken its first step away from yield curve control and will allow 10-year yields to rise to as high as 1%.
If Japanese investors were to find the returns on their country’s debt more attractive without currency risk, the drop in demand for U.S. debt would push Treasury yields higher. That would apply upward pressure on the cost of capital for U.S. businesses.
The cost of doing business has increased as the easy money era has come to an end. We expect the 10-year yield to continue trading in a range of 3% to 4% over the next year.
Absent further shocks, we would also expect reduced volatility in the financial markets, with that stability conducive to investment and growth.
The bond market, though, is not yet convinced. There are too many potential shocks brewing.
It will take the end of interest rate hikes and then the imminent start of their gradual reversal before the yield curve is allowed to resume its normal shape.
If a recession is indeed avoided, it will be one of the few times that an inversion of the yield curve did not result in a recession. We attribute that possibility on the uniqueness of the pandemic shutdown, the government’s response to the crisis, and its commitment to rebuilding the U.S. infrastructure.