Higher for (even) longer

The sharp sell-off in US 10-year Treasury bonds this autumn has primarily reflected markets coalescing around expectations of a higher natural long-term policy rate, greater inflation volatility, and a shrinking Fed balance sheet. We see these trends maturing further and now see 10 year US Treasury yields averaging 4.2% over the long term: 40 basis points above our previous forecast. 

• We now see 10 year Treasury yields averaging 4.2% in the long run – 40 basis points higher than our prior forecast of 3.8%.
• We believe the Federal Reserve's long-term policy rate has moved higher from 2.5% to 3%, supported by a higher "natural" rate of interest.
• We see scope for the term premium to normalise further as predictable sources of Treasury demand fade, policy rates gradually decline, and investors seek greater compensation for inflation volatility over the long run.  

Long-dated US Treasury bonds have sold off sharply this autumn, surprising many investors and taking yields on the benchmark 10-year bonds to levels last seen in 2007. It was a stark contrast to the first half of 2023, when long-dated Treasury yields remained low, depressed by expectations that the Fed would cut policy rates quickly and deeply in response to an expected recession in late 2023 or early 2024.¹ We now forecast a milder economic slowdown in the US accompanied by only about 75bps of rate cuts next year, implying that policy rates will remain restrictive for some time and long-end bond yields are unlikely to fall sharply from current levels.² While these near-term cyclical factors will contribute to ongoing volatility in the Treasury market, the maturing of structural trends in in the background has motivated an upward revision to our long-run forecast for the 10-year Treasury yield.

A key driver for this in our view durable rise in 10-year Treasury yields, is that the Federal Reserve's "neutral" long-term policy interest rate has moved higher than the 2.5% stated since June 2019.³ We estimate the US natural policy rate, at which monetary policy is neither restrictive nor accommodative, today at about 3-3.25%. This is consistent with the latest projections from the Fed's open market committee, which show a widening range for the neutral policy range of 2.4-3.8%. Market pricing of the long-run neutral rate can be proxied by the one-year Treasury yield in 10 years' time (see Figure 1 A).

Figure 1: (A) 1-year Treasury yield in 10-years' time  

Figure 2: (B) US term premium models

Since future policy rates reflect inflation and growth expectations, this may reflect an emerging belief on the Fed that inflation will be more volatile in the years ahead. We have expressed this view for some time due to a number of structural factors, namely demographics, decarbonization, deglobalisation, and higher debt levels. At the same time, greater public spending on the green energy transition may raise long-run GDP growth by fortifying the supply side of the economy. Advances in artificial intelligence may further unlock productivity improvements that support stronger long-run economic growth, contributing to higher policy rates and consequently sovereign bond yields. 

The long end of the yield curve has also seen the 10-year term premium, the extra compensation investors demand for holding longer-dated government debt, rise sharply in H2 2023. The term premium can be proxied by the difference between short-term policy rates and 10-year yields. While it cannot be observed directly, two models estimate its value: Adrian, Crump and Moench (ACM) and Kim-Wright (KW), using slightly different methodologies. Both exhibit a sharp rise in the second half of 2023 (see Figure 1 B). 

We see several reasons for this normalisation of the term premium to its long-term trend to continue. First, as the Fed's policy rate declines toward neutral from its current level, we expect a bull steepening in the Treasury yield curve to add upward pressure to the term premium as short-end rates fall below long-end rates. Second, we expect heightened inflation volatility to fuel demand from investors for additional yield compensation going forward, creating an additional channel through which the term premium may rise further over the long run. Third, research estimates that every 1% reduction in the Fed's balance sheet holdings should steepen yield curve by roughly 3 basis points.⁴ Further curve steepening resulting from a shrinking Fed balance sheet is likely to exert some degree of upward pressure on the term premium. 

Finally, while the Fed's balance sheet normalisation reduces a predictable domestic source of Treasury demand, foreign demand for Treasuries is also slowing. China now holds USD 805 billion of US treasuries, its lowest share since mid 2009, while Japan's share of Treasury holdings is down by USD 210 billion from a peak of USD 1.33 trillion in November 2021. While this is not worrisome on its own, the diversification of reserves away from US Treasury notes will add to upward pressure on the long end of the curve and support a higher term premium, all else equal. 

With these structural factors in mind, we now expect the US 10-year Treasury to yield 4.2% in the long-term relative to our prior forecast of 3.8%. While the increase is not dramatic, it represents a significant departure from the 2.5% average yield on 10-year Treasuries in the post-global financial crisis decade from 2009-2019.