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Rising Bond Yields, Tighter Financial Conditions, and Hard Landing Risk

A 16-year High in the 10-year Bond Raises Costs and Risk

The 10-year bond is the benchmark rate that the market uses to price all sorts of financial assets for both households and businesses.  For exampale, it is used in valuation models of stock prices, loans to companies and the mortgage market.

Monetary policy from the FED has raised rates but the US consumer has remained immune.  Taming inflation with rising short-term intrest rates was not being transmitted to the market normally.  Part of the reason is the strong US economy and the other part is low fixed mortgages of around 2 to 3% for many consumers.

However, the 10-year bond has an immediate impact on businesses and consumers.  In addition, valuation models now account for a higher hurdle rate, the cost of capital, meaning that future cash flows have to be discounted at a higher rate resulting in a lower valuataion.   This has woken up the market and we have had a sell-off, especially of risky assets.

Mary Daly, President of the San Fransisco FED, in an interview noted that tightening financial conditions in the past 90 days have had an effect and could mean no further action by the FED.  The indicators are moving towards the right direction but not fast enough, thus today’s payroll report is important.

Update:  Jobs Market Report at 336K versus 170K market estimate.  Thus, much higher than expected.  We should expect interest rates to stay higher for longer and also to go up from here.  The 10-year bond has gone up and as well as the volatility index, VIX.

Are higher bond yields signaling a hard landing risk?

As mentioned earlier, the 10-year treasury yield serves as a benchmark for long-term interest rates and is closely watched by investors. Changes in the 10-year yield can have significant implications for various sectors, including housing, consumer lending, and equity markets. Investors often use the 10-year yield as an indicator of market sentiment and make investment decisions based on its movements.

Bond yields serve as a barometer for the overall health of the economy and the financial market. Investors closely monitor yields as they are an indicator of market sentiment and risk appetite. Rising bond yields often indicate economic growth expectations, while falling yields may suggest economic uncertainties or a lack of investor confidence.

Since early 2022. the US central bank, FED, has raised interest rates 11 times from about zero to over 5%.  Inflation has fallen, but at 3.7% (August) it is still 2% above the Fed’s 2% target.  This means more work has to be done.

While the yield on the short-end, US treasuries, follows FED policy, longer term bond such as the 10-year treasuries incorporate additional risk factors. The first factor is ‘expectations’ about future changes in FED rates and the other is the ‘term premium’ risk which covers other risks.   These other risks could include the probability that FED monetary policy gets things wrong and inflation escalates or in the worst case the US goverment defaults (very unlikely but this theoretical risk is in the risk premium).  Thus, an investor that has to deal with more risk for holding an asset for a longer period of time. Previously, investors were not being compensated by holding the longer 10-year bond.  This has gone up by a 1%, or 100 basis points.

One view in the market is that it is suppy and demand related.  The FED has been reducing its holding of 10-year US treasuries and perhaps China is doing the same.  These government buyers are called price-insensitive.  The buyers that remain are price sensitive thus cognizent of risks like greater uncertainty, economy slowdown and they want compensation for that risk.  The recent risks of turmoil in the US House of Representatives and a US government shutdown are incorporated in the term premium.

Thus, for traders and investors this means higher risk and a greater chance that the FED will overshoot on policy and the chances of a hard landing increase.   Don’t forget that higher yields in the US have an effect on interest rates worldwide causing the US Dollar to gain strenght and pushing inflation worldwide.