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The US 10-year bond rate at 4.5% is considered neutral, even if inflation falls (as the real yield should be higher).
We note that the 10-year Treasury yield (US10Y) is at risk of rising towards 5%. As long as monthly readings of 0.3% (or higher) for the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) are printed. But the latest core PCE deflator came in at 0.2% per month. Triggering these measures could eventually prompt the Fed to cut. So, where are we now with respect to the 10-year bond yield?
First, note our theory that the 2000s provided a correct vision of a “neutral middle environment.” That decade saw an average US inflation rate of about 2.5%, coincided with an average Federal Reserve funds rate of 3%, and an average 10-year Treasury yield of about 4.5%. See more here.
And so if we are In order to achieve a smooth landing and contain inflation, the funds interest rate should not be less than 3%. This determines the final floor. It is possible to raise this minimum, say in the 4% area, if some weaknesses in inflation persist. All of this is important to determine where the 10-year return could go.
Our analysis of the first decade of this year suggests that the 10-year equilibrium yield is around 4.5%, and this actually brings the funds rate down to 3%. A higher funds rate could easily pressure 10-year notes above 4.5%. Essentially, the current 10-year yield does not necessarily represent stark value, even if inflation falls.
The real 10-year interest rate in the United States is still only 1%. The neutral level is 2%. A lower CPI does not necessarily mean lower revenues…
Source: ING estimates, Macrobond
A lower interest rate could push the bearish limit into the 4% region on the 10-year bond
In addition, we note that the average ten-year real return since the 1960s has been around 2%. It is now around 1% (based on printed inflation rates). Assuming a return to “normal rates” (which we do), we should look for a real interest rate of 2% over the 10-year period. See chart above.
If inflation falls by 1%, this will result in a real rate of 2%. However, this leaves the 10-year Treasury yield unchanged. This is important, because it highlights the fact that the 10-year Treasury yield does not necessarily have a good reason to fall simply based on the idea of lower inflation.
But here’s why the 10-year Treasury yield might fall:
Interest rate cuts usually coincide with a decline in longer-term bond yields. See here for more; It shows that significant falls are typical before and after the first cut. Accordingly, if the Fed begins to taper in the coming months, a move to 4% (or lower) for the 10-year Treasury yield would not be unusual.
In fact, we are calling for such an upward movement. It will bring with it a rationale for asset managers to take tactically long positions at an early stage (before the first cut), and for liability managers to either issue or lock in interest rates at a later stage (after the first few cuts). However, we believe that this window will be short (no more than a few months), and will end before the Fed completes its interest rate cutting cycle.
Ultimately, 5% is the 10-year level that is still being debated
However, a 10-year Treasury yield at 4% (or lower) is not an equilibrium outcome, as lowering interest rates would coincide with the building of a positive yield curve. The 2000s-style normal (average) curve would include a premium of 150 basis points in the 10-year yield.
This quickly brings the 10-year rate back to 4.5%. If the funds rate fails to return to 3%, say the lows of 4%, we can quickly see a case for a 5% 10-year yield. Financial pressure factor / issuance pressure We can also reach the 5% level, even from the 3% minimum funds.
Bottom line, the 4.5% 10-year bond yield we see today is neither high nor low. It’s a bang on what we consider neutral. Balance is a big word, but it’s here in our opinion. Even if inflation falls, the 10-year real yield is too low to simply decline accordingly.
The key element is lower interest rates, as this usually leads to lower longer term interest rates. We will reach 4% over the 10 years as the Fed rate cut discount tightens and the Fed begins cutting.
But this goes beyond the negative side. So, barring a systemic collapse, don’t expect to stay there. Add to that additional financial factors and a 5% rate seems fairer (above normal), after the early stages of interest rate cuts.
Hence, the more natural outcome over the medium term is for the 10-year bond yield to tend to stabilize near 5% rather than 4%.
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Editor’s note: The summary points for this article were selected by Seeking Alpha editors.
