Between the US elections and the presidential inauguration, markets are now in something of a “calm before the storm”. Investors are analyzing the implications for yields US Treasuries.
“We continue to expect higher medium- and long-term Treasury yields, with a steepening of the curve as government rate cuts Federal Reserve anchor i short-term returns. So much so that we could reach a 10-year Treasury yield of 5% as early as the first quarter of 2025.” He underlines it Arif Husain, Head of Fixed Income and Chief Investment Officer, Fixed Income, T. Rowe Price explaining that with the new US administration there will be new relevant information to take into consideration and, for sure, there is some uncertainty and different scenarios. A 10-year Treasury yield of is possible 6%? Why not? We might consider it, though, when we move to 5%.
What could drive higher long-term Treasury yields
US fiscal expansion persists, expert emphasizes, underlining that the US budget deficit for fiscal year 2024 is of 7.0% of gross domestic product (GDP), according to the Congressional Budget Office. With the Trump administration promising to cut taxes, there is little chance the deficit will decline significantly. The Treasury Department will have to continue to flood the market with new debt issues to finance the budget deficit, pushing the rising returns. Furthermore, one must consider that most other governments around the world are doing the same thing, pushing global yields higher as they compete for demand. Often, the US fiscal situation is viewed in isolation, but it may be a grave mistake to do so, considering that many government budgets afterCovid has swelled globally.
The US economy remains healthy. It appears that the Fed has successfully guided the economy to a soft landing. We see little chance of a recession on the horizon, especially if the post-election pent-up demand scenario plays out. The Fed It also appears determined to continue easing monetary policy, even as markets and policy makers have rapidly moderated the number of rate cuts expected over the next 12 months, raising the prospect of a recovery in inflation. It seems that the road to an economic recession must pass through a split in the financial markets.
Foreign demand for Treasuries is declining
There is evidence that foreign demand for Treasuries is declining. Japanese Treasury reserves fell to about $1.1 trillion in September 2024 from a peak of $1.3 trillion in 2021. With the Bank of Japan preparing to raise rates again in 2025, more Japanese investors could abandon US Treasuries for their domestic market. U.S. Treasury reserves held by China have steadily declined to about $770 billion in September 2024 from about $1.1 trillion in 2021. Treasuries have become more volatile than other high-grade developed market government bonds. quality, and even of some emerging market sovereigns, potentially driving away some investors.
Make Inflation Great Again
Inflation has moderated recently, but many policy initiatives appear to support both inflation and growth. Tariffs, for example, are likely inflationary. But of all the new US administration’s campaign promises, future changes in immigration policy would likely be the biggest driver of inflation. The counterargument is that, in President-elect Trump’s previous term, inflation stagnated as companies absorbed price changes. Has the pandemic experience changed the ability to pass on price increases to customers? What seems clear, however, is that without help from the Middle East, it will be difficult for US oil suppliers to create an offsetting deflationary impulse through the energy channel.
What could hold back Treasury yields
Husain explains that regulatory changes could stimulate demand for Treasuries from US banks. The Fed’s recent guidance on banking regulation, which clarifies the scenarios in which banks can convert i Treasury in liquidity through the Fed’s discount window, they could encourage banks to hold more Treasuries instead of reserves. Banks that need liquidity under stress (as occurred during the March 2023 regional banking turmoil) can now receive credit in stress tests for borrowing reserves using Treasuries held at the discount desk. The Fed is trying to ease the long-standing market stigma that over-the-counter lending is a last resort for troubled banks.
Also fears of a deterioration of the Fed’s independence could influence quantitative tightening (QT). Rumors that the Fed is becoming less independent and increasingly subject to political pressure have swept through the US interest rate market United States, mwhile the president-elect pondered whether he should exert greater influence on the central bank. Political forces could encourage the Fed to slow or stop QT earlier than is prudent or even restart bond purchases. Even mere rumors of the Fed’s deteriorating independence could lead markets to price in greater demand for Treasuries.
Limited market reactions make no sense
After an immediate post-election jump to nearly 4.50%, the 10-year Treasury yield at the start of December was about 10 basis points lower than it was on November 4, when it stood at 4.29%, concludes the expert explaining that the difference between two- and 10-year Treasury yields was 7 basis points in early December compared to 10 basis points the day before the election. These yield movements, in our opinion, do not make much sense. Even taking into account that it will take time for the new US administration to implement the programs, “the US pre-election political uncertainty has dissipated and long-term Treasury yields are expected to rise, making the yield curve steeper.”
