US yields above 3% will spell trouble

LONDON: The outlook for US interest rates has shifted, as investors bet that recent cracks in the economy and financial markets will force the Fed to slow or even halt its projected path of rate increases.

This should also be playing out in the bond market, pushing down long-term yields and easing financial conditions, thereby helping to limit the fallout from a weakening economy and fragile stock market.

Yields have come down a bit, but not as much as expected, thanks to a steady build-up of factors that should push them the other way.

October was the worst month on Wall Street in seven years, the FAANG group of top tech stocks — Facebook, Amazon, Alphabet, Netflix and Google — lost almost $1 trillion in market cap, Apple skidded into a bear market, and some US economic indicators — namely the housing market — turned red.

If growth slows at this stage of the cycle, the chances of recession rise and the Fed will have to put the brakes on, or maybe even reverse gear all together. The all-knowing, all-seeing bond market should discount that, and yields should fall.

Fed chair Jerome Powell last suggested that rates are already close to neutral, the level that neither accelerates nor restricts the economy. His comments pushed the 10-year yield to its lowest since September.

Only one quarter-point rate increase next year is fully discounted in money markets, compared with two a couple of months ago. But the 10-year yield remains above 3%, barely 20 basis points off its peak in early October just before the Wall Street lurch and “tech wreck”.

A growing risk for markets and the economy is that it holds at that level and starts trending higher again.

Emerging markets, which are most exposed to US borrowing costs and the dollar, will be vulnerable.

Record supply, high hedging costs, the Fed unwinding its balance sheet and emerging markets potentially selling treasuries to support their domestic currencies is a potent mix that could easily keep the 10-year yield above 3%, even if the historically long economic and market cycles roll over.

The demand and supply balance in the market for treasuries is looking increasingly short on demand and long on supply. As Luke Gromen at the research firm FFTT notes, there’s a race going on: will investors’ demand for a port in any coming storm be enough to offset that widening imbalance?

Mr Gromen calculates that the US treasury will roll over as much as $8 trillion in debt next year and issue $1.3 trillion in new bonds. In addition, the Fed has already started winding down its portfolio.

That’s a lot of paper for the private sector to buy, especially as the current level of US yields makes it prohibitively expensive for foreign investors to hedge bond purchases.