Interest rates have been making headlines recently, with the benchmark 10-year Treasury note yield briefly exceeding 4.5%, the highest level since 2007. However, while this may seem like a significant development, it is actually just a return to normalcy.
Historically, the 4.5% yield represents the long-term average for U.S. government debt, going all the way back to 1790. Jim Reid, Deutsche Bank’s head of global fundamental credit strategy, pointed out this observation. He noted that despite elevated inflation and predicted record peacetime deficits, interest rates are only now reaching normal historical levels.
The positive aspect of this return to normal is that value has also returned. Longer-term investors should find it less risky to invest in Treasuries now than in the past decade. However, there have been stunning losses in supposedly riskless government securities, with some selling at less than 50% of their face value.
While the Federal Reserve held its federal-funds target unchanged at 5.25% to 5.5% in its recent policy meeting, it confirmed its intention to keep interest rates higher for longer. Fed Chairman Jerome Powell emphasized that policymakers would proceed cautiously. The updated Summary of Economic Projections from the Federal Open Market Committee (FOMC) suggests a quarter-point hike in the fed-funds target this year, with a total half-point rate reduction by 2024.
Short-term rates are expected to remain in the 5% range through 2024, indicating that the 4.5% yield on the 10-year Treasury note is not its ultimate destination. Historically, the fed-funds rate and the 10-year Treasury yield have tended to peak around the same level. However, this time, the Fed’s previous quantitative easing has lowered the term premium, which means that the term premium should rise and lift yields as the Fed reduces its holdings of Treasury securities while the federal government faces significant deficits.
Chris Verrone, head of Strategas’ technical and macro research team, predicts that the 10-year Treasury yield will reach 5.1%-5.2% based on his charts. He also suggests that the equity market may become uncomfortable with the level of interest rates, as cyclical stocks have stopped outperforming defensive names in the past month.
Investors who have grown accustomed to historically low interest rates now have to contend with money that no longer comes at no cost or even less after considering inflation. It will be interesting to see how both the economy and the markets adjust to this return to normalcy.
In conclusion, while the recent rise in interest rates may seem significant, it is actually just a return to historically normal levels. It has implications for investors, both in terms of the risks associated with government securities and the performance of the equity market. As interest rates continue to normalize, it will be important for investors to adapt their strategies accordingly.