Why Treasury Yields Are Up
The top question from clients right now is why Treasury yields have risen so much. The move has been gradual over the past few months, so the level matters more than the speed. When the 30-year Treasury yield touched 5.3%, it grabbed a lot of attention.
The main driver is changed expectations for Fed policy over the next two years. At the start of the year, markets expected two or three rate cuts; some expected fewer, one or two. That view has shifted hard. Markets now price in a hike or two by the end of this year or into next year.
The 10-year Treasury yield is up about 60 basis points, or 0.6%, year to date. Most of that comes from expected short-term rates. Federal Reserve models that break down the drivers show inflation expectations as a minor factor, secondary to the Fed's hawkish turn and a higher expected short-term rate.
Fiscal worries have made headlines, but they do not appear to be a key driver. The heavy U.S. debt load has been known for a while, and no one just discovered it. The economy is also strong. With the Fed funds rate in the 3.5% to 3.75% range - arguably neutral or even a bit accommodative - and the economy growing, a positively sloped yield curve is what you should expect. The rise in yields, while it makes headlines and makes some people nervous, signals a fairly healthy economy.
The Case for Keeping Bonds
Fixed income should be viewed as part of the whole portfolio. Diversification still gives bonds value. Much of the negative talk about bonds traces back to 2022, when fixed income posted negative returns in a very different environment. Use 2022 as your reference point, and it will look like bonds fail to balance a portfolio or offset equities.
More recently, yields sit in the 4% to 5% range, which is a strong starting point. One of the best predictors of future fixed income returns is the starting yield. Many people say the 60/40 portfolio is dead. That view is wrong. Despite recent shocks, the broad diversification and long-term value of fixed income holds up.
High yields have tempted investors, especially in the UK, where yields have reached their highest levels since around the early 2000s.
Reading the Data and the Fed
It has been a data-heavy week, with the jobs report on Friday as the main event. There are gaps in the signals - input prices on ISM services versus how Fed official Waller describes inflation.
Two ISM reports come out, one for manufacturing and one for services. The U.S. is more of a services-driven economy, so services carry more weight. The ISM services prices index rose to its highest level since 2022, which cannot be ignored.
The bond market today latched onto comments from Waller that read as dovish. He seems to think inflation will come down. He also said that if inflation comes in hot next week, he would be inclined to raise rates as soon as the September meeting. That shows inflation pressure is very much present. Pulling together the labor market, the growth rate, and ISM surveys, more hotter-than-expected data on any of those fronts could push some Fed officials from the hold camp into the hike camp.
The September meeting looks live, close to a coin flip. The next jobs print and the CPI are the things to watch.
Tomorrow's jobs report is a good read on where the economy stands, but it matters less than it did a year ago. Back then the focus was on the labor market driving Fed decisions. Now the focus has flipped to inflation. Waller's comments were useful as an example of someone who may have moved off the hold position, showing at least some confidence in where inflation is headed.
The real focus is next week. The Fed enters its blackout period, so no more Fed officials will speak before the meeting. Next Friday's CPI is key. If it comes in hot, expectations for a hike will likely rise, and that CPI print may be the catalyst that decides which way the coin flip lands.
