Much Ado About Treasury Volatility

Spiking bond yields have been center-stage in the equity-market correction (sharp, sentiment-driven -10% to -20% pullback), as 10-year Treasury yields pierced prior year-to-date highs and surged further. Between July’s end and mid-October’s high, rates soared from just under 4% to brush 5%, fanning fears there was further to go—with many pointing to deficits, slack bond demand and potentially more rate hikes ahead.^[i] But in our view, this swing was chiefly about sentiment—and such moves often reverse as fast as they strike. Now it seems we may be seeing signs of just that.

Fundamentally, inflation and inflation expectations heavily influence bonds’ longer-term direction. So you might expect that, with inflation falling from the consumer price index’s (CPI) 9.1% y/y peak in June 2022 to 3.7% in September—with further irregular declines expected—rates would be declining, too.^[ii] But typical of forward-looking markets, Treasurys priced in inflation’s slowdown beforehand. As folks gradually appreciated—consciously or no—that inflation was cooling, its surprise power and ability to sway bond markets waned. Five-year “breakeven” inflation expectations peaked at 3.6% in March 2022—that is, markets expected CPI to average 3.6% over the next five years—but they fell to just above 2% by September 2022 and have been mostly pinned there since.^[iii] So this fundamental force that would ordinarily pull rates lower faded.

Meanwhile, economists continually pushed out their recession forecasts. Most now have been completely revised away. Sentiment swung hard. Fears pivoted to a “too hot” economy and, more recently, Treasury supply overwhelming demand. Still others argued a rise in the mysterious “term premium”—extra yield to own long-term bonds to compensate for the risk of changing rates over the bond’s life—underpinned the rise.

But since 10-year Treasury yields kissed 5% October 19, rates are now back down to 4.57%—at levels dating back to September and retracing almost half the rise.^[iv] What changed? Very little. Some point to last week’s US Treasury announcement it will sell less debt than expected this quarter. Instead of borrowing $852 billion in Q4 like Treasury anticipated in July, it cut estimated borrowing to $776 billion, citing higher tax receipts.^[v] It also signaled slightly lower-than-anticipated longer-term Treasury issuance—$112 billion versus $114 billion expected, with 10- and 30-year Treasury debt sales slowing.^[vi] And it now projects only one more quarter of stepped-up issuance versus several more that major dealers had penciled in. Reduced borrowing means reduced bond supply. But none of these seem like big shifts to us.

Others suggest the real reason rates rose was the deficit itself, presuming hawkish “bond vigilantes” were the issue. If the deficit explained yields’ recent rise, they shouldn’t have reversed fast—and there should be a clear widening gap between US spreads and those of countries running projected surpluses. Consider Exhibit 1, which plots the difference between US rates and developed world countries forecast to run 2023 budget surpluses. It may appear the widening gap between American and Swiss rates supports the notion deficits are to blame. But it doesn’t hold against any of the other countries predicted to run 2023 budget surpluses—including oil-rich Norway, which has the largest surplus of all as a share of GDP.^[vii]

Exhibit 1: US Rates Minus Surplus Countries’

Source: FactSet, as of 11/7/2023. Difference in 10-year sovereign yield, 11/6/2020 – 11/6/2023.

Look at these data differently for a deeper view. Exhibit 2 shows the gap between Swiss rates and everyone else’s. The gap began widening in 2022, when inflation started really heating up in all these countries ... except Switzerland, which saw harmonized CPI peak in August 2022 at 3.3% y/y.^[viii]

Exhibit 2: US and Surplus Countries Minus Switzerland

Source: FactSet, as of 11/7/2023. Difference in 10-year sovereign yield, 11/6/2020 – 11/6/2023.

Still others say it isn’t deficits or borrowing plans, but changes in the term premium—reflecting a shift up in expected future rates. The problem here, though, is that it isn’t directly observable. It can only be guesstimated using a variety of academic approaches. There is no way to actually prove or measure what the term premium is—or, crucially, why it may shift. These kinds of constructs, in our view, seem more to us like a fruitless effort to explain volatility after the fact than a causal explanation of where rates are headed.

And that, folks, brings us to the point: Don’t overthink volatility. Even bonds demonstrate it, sometimes significantly. It doesn’t always have a bigger, badder meaning—and it can reverse quite fast.