Recently, the yield on 10-year U.S. Treasury bonds has surged close to 4.3%, marking a significant increase of 70 basis points from its low a month ago. Interestingly, this rise comes on the heels of the Federal Reserve's unexpected 50 basis point rate cut on September 17, coinciding with heightened expectations for further cuts and a looming recession. In retrospect, this period appears to have been the bottom for interest rates. Here are some insights for consideration.
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What cause the surge?
The increase in interest rates is not surprising. We have previously emphasized the need to think and act contrary to expectations surrounding rate cuts. The timing of rate cuts can often coincide with the bottoming out of rates, similar to what we saw in 2019. If investors continue to bet on falling rates by buying bonds when cuts are announced, they may be making a mistake. In fact, over the past year, any linear extrapolation of rate cut expectations at any given moment has often proven to be incorrect.
Three Key Reasons
Overextended Expectations: The market may have priced in too many rate cuts too soon.
Reflexivity of Rates: When rates decrease significantly, it can hinder further declines. Lower financing costs can boost economic growth, which in turn reduces the need for aggressive rate cuts.
Recent Market Dynamics: The "Trump trade" has gained momentum recently, providing additional support for rising yields.
How High Will Rates Go?
Another intriguing aspect is that both rising and falling rates tend to overshoot expectations. The previous drop below 3.7% surprised many, just as current levels near 4% may do so again. Various methods, including natural rate calculations, suggest a central tendency around 3.8% to 4%. However, there is no guarantee that rates will revert immediately after surpassing this range; similar patterns have occurred repeatedly over the past year.
Future Trends:
Before any further rate cuts occur, there may still be trading opportunities since excessively high rates could trigger reflexive market behaviors. It is unlikely that rates will drop dramatically right away (CME futures still price in a potential cut in November). However, breaking below previous lows may prove challenging. The natural trend toward recovery in the U.S. economy post-rate cut, combined with policy changes following the upcoming election, complicates any downward trajectory.
Impact of the Upcoming Election
The timing and extent of changes due to the election are particularly tricky to navigate. For instance, after Trump's victory in 2016, interest rates jumped by 80 basis points; however, this time around, some movements seem pre-emptive.
If there is another significant spike after this election, it may present an opportunity for investors to go long on bonds. As the economic landscape becomes clearer post-election and policies solidify, we could see an end to this cycle of declining rates.
In summary, while recent movements in Treasury yields reflect complex interactions between market expectations and economic fundamentals, investors should remain vigilant and adaptable as conditions evolve in response to both monetary policy and political developments
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