Now that the 10-year Treasury yield has briefly burst through 5% for the first time in 16 years on Monday, there may be more reasons to think that it could go even higher.
In a note, Lisa Shalett, chief investment officer and head of the global investment office for Morgan Stanley Wealth Management in New York, points to the possible need for investors to include the outbreak of global conflicts and the questionable sustainability of the U.S. debt into the premium that encapsulates all of the risks of holding long-term government debt to maturity.
Term premium is the theoretical and unquantifiable number which Wall Street has been obsessed with because it seems to be driving much of the recent surge in long-term Treasury yields. It refers to all the risks which investors want to be compensated for to buy and hold government debt — including stronger long-term economic growth, higher-for-longer increased rates, inflation uncertainty, and an increased supply from Treasury.
Expectations for future U.S. price gains have jumped sharply since the Israel-Hamas conflict erupted about two weeks ago, while the growing federal-government debt and costs to service it may “ultimately squash growth or unleash higher inflation, depending on the Fed’s ability and desire to monetize it,” according to Shalett.
“Although many factors are contributing to higher rates, such as stronger-than-expected growth and the Fed’s inflation focus, it may be time to contemplate whether global wars and questions about U.S. debt sustainability also merit a higher risk premium,” she wrote on Monday. “The federal debt already exceeds $33 trillion, and servicing costs, now close to $600 billion, are poised to surpass total defense spending by 2033.”
Moves in the 10-year yield
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tend to reflect investors’ assessments of the U.S. economy, policy volatility and long-run capital returns. By contrast, shorter-term rates on everything from the one-month Treasury bill
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to the 2-year note
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are usually a reflection of hawkish Federal Reserve speak and the probability of rate hikes.
A number of factors are at play right now when it comes to the benchmark 10-year yield, used to price everything from mortgages to student and auto loans. One of them is a surge in Treasury issuance and “dearth of buyers (no Federal Reserve, no regional banks, fewer foreigners), raising legitimate questions about U.S. debt sustainability,” according to Shalett. Another is the market’s view of the real neutral rate — or level of short-term interest rates that’s expected to prevail when the economy is at full strength and inflation is stable — “which may be higher than previously assumed.”
Since Oct. 7, when the militant group Hamas launched a surprise attack on Israel, Treasurys “have barely experienced a flight-to-safety trade,” she said. Instead, the 10-year yield has recently been jumping as the result of aggressive selloffs after having already soared almost a full percentage point from mid-July to Oct. 2.
On Monday, the 10-year Treasury touched an intraday high of 5.022% before pulling back and finishing the New York session at a one-week low of 4.836%. Rates on 2-year notes through 30-year bonds also ended lower, reversing direction from earlier in the day when traders and investors were more focused on the likelihood of no U.S. recession. U.S. stocks
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SPX
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finished mostly lower.
Morgan Stanley Wealth Management, a division of New York-based Morgan Stanley MS, had almost $4.8 trillion in client assets as of Sept. 30. Shalett recommended that investors consider moderating any “large equity overweights to account for the risks of a structurally higher U.S. cost of capital, while adding to real assets—including gold, commodities, infrastructure, energy transport and noncommercial real estate—as a portfolio hedge given non-zero odds of stagflation.”
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