With the federal funds rate and term premium likely to remain low, Head of US Securitised Products John Kerschner argues 10-year bond yields for this cycle may have already peaked.
- On average, 10-year yields are anchored to the fed funds rate.
- We expect the fed funds rate will average between 0.5% and 1.0% over the next decade and the term premium will be negligible.
- Thus, it is difficult to imagine a scenario that results in 10-year yields averaging above 1.0% to 1.5% in the decade ahead.
“Everything should be made as simple as possible, but no simpler.”
– Albert Einstein
If you accept that U.S. Treasury 10-year yields should be close to the average of the fed funds rate over the coming 10 years, plus or minus a “term premium,” then 10-year yields for the current cycle may have already peaked, at 1.74% back in March.
Is this a big “if”? History suggests it is not. As the average fed funds rate (the primary policy interest rate) has fallen, decade by decade, so has the average 10-year Treasury yield. In the 1990s, when the fed funds rate averaged just above 5%, the 10-year yield averaged 6.7%. Then, in the 2000s, the average fed funds rate fell to just below 3%, and 10-year yields followed, averaging around 4.5%. Finally, in the last decade, the fed funds rate pushed even lower, to just 0.7%, and the 10-year average yield fell to 2.4%.1 Put simply, 10-year yields are anchored, on average, to the fed funds rate. That they don’t replicate the fed funds rate has been due to some additional “term premium” – extra yield demanded by investors as compensation for lending money for longer periods of time – added to the average fed funds rate.
While 10-year yields could certainly see brief spikes above the highs set this summer, we don’t foresee the fed funds rate averaging anywhere close to 1.75% over the next decade, nor do we think the additional term premium will amount to much, if anything. As such, 10-year yields may have peaked.
Where are Fed Funds Going?
Part of the reason we expect the fed funds rate to be low in the decade ahead is that every time the Federal Reserve (Fed) has tried to raise interest rates over the last 40 years, their tightening cycle has stalled at increasingly lower rates. Furthermore, the last two times the Fed raised interest rates, the central bank had to drop them again within roughly a year, all the way to zero.
Exhibit 1: Cycle Peaks in the Federal Funds Rate
Source: Bloomberg, as of January 1981 to 15 September 2021.
Remember, even before COVID-19 shocked the global economy, the Fed had already begun a path to lower interest rates. This was necessary because after the fed funds rate reached 2.5% in late 2018, the 30-year mortgage rate neared 4.5% and the housing market stumbled. Average home price appreciation fell rapidly from about 7% to 2%.2 In hindsight, the U.S. economy – for whatever reasons – has increasingly struggled to thrive even after a modicum of interest rate increases. Looking ahead, we simply do not see the causes or conditions to suggest the economy will become less sensitive to higher rates in the decade ahead. On the contrary, history suggests it will become even more vulnerable to higher rates.
While forecasting is difficult, our base case is for the fed funds rate to be stable at near 0% for a few years, then gradually increase to 2.5%, stay there for a year or so, and then (almost) inevitably be cut back to 0%. In this scenario, the average fed funds rate over the next decade may only be 0.5%.
Exhibit 2: Scenarios for the Next 10 Years of the Fed Funds Rate
Source: Bloomberg, Janus Henderson, as of 15 September 2021.
If we look at the path of the federal funds rate after the Global Financial Crisis (GFC), as shown in Exhibit 2, we get an even smaller average of just 0.38% over the next decade. But let’s be conservative and imagine a strong economy, with low sensitivity to rising rates, and a hawkish Fed. In this scenario, the Fed may be quicker to raise rates, raise them more aggressively (to 2.5%), keep them there longer and, after flirting with near zero rates again, hike them back to 2.5%. While this would be an incredibly quick cycle – on par with the historically aberrant 2020-2021 cycle – even this more conservative scenario results in an average fed funds rate of just 1.25%. And yet, today, the 10-year Treasury yields around 1.3%.3 Are current 10-year yields pricing our most conservative scenario, zero term premium, or both?
What is the Term Premium Likely To Be?
Today, the term premium is actually negative, at near -0.5%.4 And today’s negative number is not some quirk resulting from the Fed’s record-setting interventions in the bond markets as a result of COVID-19. Rather, the term premium has been in negative territory for about the last three years. While the idea of investors not demanding a premium for additional risk —but instead being willing to pay to take additional risk —may be sound like a conundrum, we believe it has a reasonable explanation.
The borrowing and lending of money (i.e., bonds) takes place in a global marketplace and currently $16.5 trillion of those bonds have negative yields.5 In our proprietary analysis, negative-yielding debt in places like Germany, Switzerland and the Netherlands is pulling down longer-dated U.S. Treasury yields, resulting in a negative term premium. While we see no reason for these broad structural factors to change across the global economy in the decade ahead, and thus it may be more reasonable to assume the term premium remains negative or turns even more negative, it is more conservative to assume the term premium averages zero for the next 10 years.
“Did you hear about the statistician who drowned in a lake with an average depth of two feet?”
– An old joke
What Could go Wrong?
Making long-range interest rate forecasts is notoriously fraught with assumptions, and relying on long-term historical and forecast average yields ignores the short-term volatility that is not only possible, but likely. Just because a lake’s depth may only average two feet does not mean you should assume the risk of drowning is zero.
But if one assumes that the Fed will not be quick to raise rates (and they have told us they won’t), and you assume that rates will not exceed 2.5% (and the last decade suggests this should be a maximum), and you assume that the term premium will be negligible (despite it being negative the last few years), it is difficult to imagine a scenario that results in 10-year yields averaging above 1.0% to 1.5% in the decade ahead.
However, we can imagine a few events that could complicate this relatively simple analysis, creating short- or even possibly long-term volatility. One is the possibility that a change in the Fed’s leadership could raise uncertainty about interest rate policy. This is a near-term issue as the term of current Fed Chairman Jerome Powell ends in February 2022 and he is not guaranteed to be given another term. However, if he is replaced, we believe the current administration is more likely to replace him with somebody more dovish than hawkish.
The more likely cause of volatility in 10-year yields is the path of U.S. inflation. The past year has taught us that shutting down a global economy is much easier than opening one back up, and we are all living with the supply-chain issues causing not only irritation, but also higher prices. However, we maintain our view that these issues will be mostly resolved by mid-2022 and thus expect inflation will return to the sub 2% level we are all more accustomed to. Nevertheless, we will continue to monitor the variables, including such things as container shipping costs and delivery lag times, to confirm our base case: COVID-induced inflation will soon be in our rear-view mirrors.
In the meantime, we encourage investors to consider Einstein’s words, appreciate the value of simplicity and consider – despite all of the current consternation about the direction of U.S. Treasury yields – that the simple analysis says they have already peaked.
1For all fed funds and 10-year yield stats: Bloomberg, as of 15 September 2021.
2Bloomberg, as of 15 September 2021.
3Bloomberg, as of 15 September 2021.
4Bloomberg, as of 15 September 2021.
5Bloomberg, as of 15 September 2021.