Each of the factors impacting long-term Treasury yields are uncertain in size and timing, difficult to measure, and therefore challenging to weigh against one another. To illustrate:
Inflation. Price growth tends to ebb and flow with the economic cycle. Factors such as a tight labor market and high corporate profits drive prices higher, until a slowing economy eases those pressures. This cycle, however, has seen prices bolstered by structural changes as much as cyclical ones. The global pandemic has drawn attention to supply chains, making access just as important as efficiency. Russia’s invasion of Ukraine may have accelerated a global energy transition. This combined focus on global resiliency points to redundancy, meaning higher costs. As these transitions are likely to require ample time and investment, inflation may be biased higher in the medium and longer term.
Combating these factors are the disinflationary impacts of technological innovation—economic efficiency drives productivity higher and prices lower—and an aging demographic. Economic theory suggests that people spend less and save more as they age. In the last economic cycle, these factors prevailed over any cyclical drivers of inflation, contributing to a low-inflation, low-rates environment. Today, the impact is less certain. Demographic disruptions have contributed to a dearth of labor supply, pushing wages and prices higher in the near term. Until the labor market is brought into balance or innovation displaces labor, this factor has contributed to stronger price pressure.
Even after a dramatic rise in the past year, the 10-year Treasury sits comfortably in its historic range
Composition of nominal U.S. 10-year yield
In the near term: the Fed is unlikely to cut rates. See the previous section for our criteria for Fed rate cuts. The cyclical and structural factors biasing inflation higher mean that the Fed is unlikely to cut rates, even as economic growth slows. In the medium and longer term, we are sympathetic to the argument that the strategic nature of ongoing tech and energy investment may bias inflation higher with a need for non-restrictive rates. In our view, though, this is unlikely to play out in the next year. Furthermore, we remind investors that neutral rates are likely to be closer to 3.0% than the “lower for longer” environment that investors became accustomed to in the last cycle.
In the longer term: monitor the productivity of government investment. Where interest rates settle is important for investors, but why may be even more important. Long-term Treasury yields can move higher for two reasons. Treasury issuance to fund productive investments may bias long-term rates higher by increasing potential economic growth (the natural rate); this may impact the range at which U.S. Treasuries trade, but in a modest and sustainable way. If, by contrast, yields are moving because of a misstep in supply and demand (the term premium), investors can expect more volatility.
Remain cautious on aggressive duration bets. While duration may well benefit in the short term as interest rates fall, the medium-term duration argument is murkier. If structural investment needs continually push the front end of the curve, why move farther out? We encourage investors to maintain a neutral position in their overall duration exposure. We prefer shorter duration in corporate credit, paired with longer duration in municipal bonds where curve structure is more attractive.
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