Episode 41: Making Sense of Rising Treasury Yields

Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is about making sense of rising treasury yields. I’m Josh Zumbrun. I’m the Director of External Communications here at Mercer Advisors, and I’m joined today by David Krakauer, our Vice President of Portfolio Management. David, thanks so much for being here today.

Thanks for having me, Josh.

So we’ve seen a lot of headlines over the kind of late summer period. Treasury yields have been rising again. And especially on the long kind of the long end of the curve as we say. Right?

The ten year yield is the highest in a couple of years. The thirty year treasury yield, which we don’t talk about quite as much, but has hit kind of 5.3%, which is the highest a nineteen year high, I think it was. We’re recording this on September 11.

By the time you’re listening, it’ll have moved again, I’m sure. But we are looking at bond yields that are, especially in the long end, kind of the highest we’ve seen in a few years, quite a few years for the thirty years. So, David, kind of help set the stage, kind of put the where the treasury is, where the treasury yields are in context for us.

Yeah. Well, you’re absolutely right. So if we look at the ten year treasury yield, I think as of today, we’re actually pushing close to 5%, which is high. But actually, really just going back two years ago, we were really at the same levels as we are right now in the ten year. But if we go further out on the curve and we look at the yield of thirty year treasuries, the gas of today, last I checked, was around 5.38% for a thirty year treasury bond, and that is the highest since 2007. And so there’s certainly been some, headlines obviously in the news, and I think, sometimes a little bit of, alarmist headlines about the rising rates, especially in the long end of the curve.

But I think just to put it in context, we still need to remember a couple things. First off, you know, it wasn’t really until 2023, 2024 where we truly were coming out of an abnormally long low rate environment that really started right after the Great Recession.

And so from the great recession really to around 2023, 2024, we had very abnormally low interest rate environment. And so it’s not that we are entering an abnormally high interest rate environment. We’re really still just exiting an abnormally low one. Prior to the great recession, if you look at treasury yields, you know, from the very early two thousands to the nineties to the eighties, the rates we’re seeing right now and the levels we’re seeing are not abnormally high. They’re actually more so in line with the longer term historical rates on treasury yields.

For those of us for those of you listening, we just put up on the screen a chart of the thirty year treasury yield going back into the nineteen seventies. And you can kinda see how, you know, these yields that we’re seeing right now on the thirty year, you don’t look at this in a historical context and say these are super high yields. You do look at the period a few years ago and say, man, things really got low there for a while. Just to kind of a helpful this chart kinda helps put it in perspective how how in some ways it’s it’s a return to what things used to to look like versus kind of completely uncharted territory.

Yeah. And and the other thing to put this into context is if we actually look at the year to date performance of bonds in general. So we often look at The U. S.

Aggregate bond index, which includes treasuries. It’s actually primarily treasuries, also some high high investment grade corporates as well as some other sectors. Year to date, the whole bond index is down around 1.3 1.4%

year to date. To put that into context, in 2022, just four years ago, bonds were down 14%.

And so, yes, we’ve seen, interest rates rise, which then means the prices of bonds go down. But year to date, we actually are are only seeing roughly around 1.3% decline in prices. And so, again, just trying to put this into context so that, you know, we’re not really viewing this as too of an alarmist, you know, scenario at the moment.

And now let’s dig into kind of the factors driving this. David, what do you see as the reasons that the the bond yield has kind of backed up again like this? What what what have been the factors driving this?

Yeah. Sure. So so really on the longer end of the curve, think about twenty, thirty year treasury yields. Certainly, one of the drivers, is fiscal policy and an an uncertainty in general rising around what our long term debt, you know, is going to do to our own finances as a company, as a as a country. And so when we think about the deficit, we are continuing to run year in and year out the federal level. We think about our debt to GDP ratio rising.

It makes sense that for twenty, thirty year bonds being issued by our treasury department that investors are demanding a higher premium to lend to the government when we have so much uncertainty about the trajectory and the path of our debt as a nation.

Just put up the chart here of debt to GDP, and you can really see here you can really see here that this has been a long term trend of of this debt going up. Kind of it’s been it’s been both parties. It’s been both, you know, different configurations of congress. It’s been over twenty five years since this has been kind of on a stable trajectory. It’s been getting worse for quite an extended period of time here.

Yeah. And and part of our annual deficit, a larger and larger part of our annual deficit is actually payments on our existing debt. And so as interest rates have risen the past couple years when it comes to the short end of the curve and what the the Federal Reserve, really pins the interest rate environment at. You know, our actual servicing of our own debt alone has become a a greater and greater portion of our annual federal deficit. And so when we think about, you know, this in context, you know, we see somewhat of a repeating cycle, whereas as our federal debt increases, the servicing cost on that debt increases, which increases the deficit. So Yeah.

It sort of feeds upon itself over time.

Spiral. And Yeah.

And so the the other point worth noting, though, just to put this into context, is that right now, you know, we are over, you know, now a 100% debt to GDP when we look at the ratio of how much, debt we have of 40,000,000,000,000, you know, to the size of our gross domestic product, GDP. Whereas Japan has been running a debt to GDP ratio of 250%, you know, well over 200% for several years. So there’s no real threshold here. There’s no threshold for, you know, this mechanism to break down. But it’s just this general uncertainty, you know, that just keeps growing over time as our debt levels have risen. Again, really starting with the great recession and and now, just sort of spiraling like Josh mentioned over time, becoming a a larger and larger focal point, you know, when we think about how much investors demand on the long end of the curve for longer dated bonds.

And now, obviously, that’s not the only factor going on in the bond market. Right? So what are some of the other factors driving this? I mean, the I think one of the ones that’s gonna jump to most people’s mind right away is the inflation outlook.

Yeah. So certainly, inflation and then and monetary policy in general, you know, is a real, another driver here. So, just to be clear, monetary policy is is really what the Federal Reserve does with interest rates on the very short end. So just a a reminder for the audience, the Federal Reserve doesn’t control directly the yield on ten year, bonds or thirty year bonds. The Federal Reserve controls the overnight rate.

But the longer the, the capital markets expect the Federal Reserve to have those overnight rates higher or if they think the Federal Reserve will raise the overnight rate and hold it there for a long period of time, that’s reflected in longer dated bonds.

Right.

And so when we think about why the Federal Reserve may raise rates higher or keep rates higher for longer, a lot of that comes back to inflation. And as we know, especially with what’s going on with the war in Iran, and the effects it’s having on the global energy markets, you know, oil now rising back up over a $100 a barrel. The inflation report even coming out today showed very clearly that energy prices, gas prices, the prices of of airfare flights, you know, all of these rate rising energy costs just continue to filter or trickle into the inflation report. And that’s just more fuel and ammo potentially for the Federal Reserve to keep rates high, potentially raise rates, you know, even further in the future. That those expectations, that affects the treasury yields going out ten years, twenty years, potentially thirty years if we, you know, think that this is gonna have a real long lasting effect.

And, I mean, we’ve talked before about uncertainty about the Federal Reserve being a little bit you know, the the Federal Reserve’s course of action in the future is a little bit more uncertain than it used to be. Right? There’s been a shift to strategy of Fed, a change in leadership at the Fed. And so kind of explain how you’re thinking about that and how that might be impacting kind of the outlook.

Well, know, you’re absolutely right.

So we have a new Fed chair, Warsh, who has come in, and he’s purposefully said that he believes that less transparency around future interest rate decisions, may actually be a good thing. And he’s voiced, you know, some concerns that maybe up until this point, in the past that the Fed was actually telegraphing too much what they were going to be doing. So, you know, the the feeling from worse is is that if the Federal Reserve telegraphs too much, then if the environment changes, they won’t have the flexibility to maybe change with it.

And so, you know, whether you agree with that or not, the fact is is that now the capital markets have more uncertainty about the future path of interest rates from the Fed.

And again, that uncertainty then leads to requiring a higher term premium on longer dated bonds like the ten year, the third year. If you don’t have a tight grip on what your expectations are, you need to plan potentially for more variance, demand more of a premium for longer dated bonds.

And then kind of the final factor is maybe the demand and and kind of the supply and demand dynamics in this market, right? I mean, this is set by market forces ultimately. And so what are some of the ways that the forces in the market might be changing and influencing what’s going on with yields?

Yes. So there’s really two things I think worth mentioning. So first off, when we look at Treasury auctions in general, we’re not really seeing a drop in demand for Treasuries and Treasury bonds, but we are seeing a structural shift slightly with who owns US treasuries in general. And so we have seen over time a slight decrease in the amount of treasuries being held by foreign central banks.

Some of that actually has to do with them increasing the amount of gold, you know, on their balance sheets, for diversification purposes and also because gold actually got recharacterized several years back as a more of a safer, asset than it used to be. So they look at, ways to balance out their own diversification. And so with this slight, drop in interest from foreign central banks, we actually have seen an uptick in interest from private entities owning treasuries, hedge funds even specifically, that may be more price sensitive, and actually introduce a little bit more volatility into the prices of treasuries in general.

So that’s one element, you know, when we think about structural shifts in in the buyers of treasuries in general.

Just a second there. I mean, I think that’s actually pretty interesting to to walk through for people. I mean so the idea, right, is that a a foreign central bank is kind of buying treasuries. It’s not looking at the price day to day and, like, trying to make a trade to do something that’s super profitable. It’s thinking about this in terms of, like, a long term an extremely long term reserve holding strategy.

Hedge funds, to the extent they’re the new marginal buyer in this market, we’d expect them to behave differently.

You’re exactly right. I mean, the International Bank of Settlements is sort of like the governing body institution that all central banks really look to for guidance on how to characterize their assets. And so as I’ve mentioned before, they actually recharacterized, you know, gold on a different tiering system.

And so the central banks are really just looking to balance out, you know, certain levels of safety by holding different asset classes. Hedge funds are doing something very different. You know, they’re they’re trying to capture carry and yield underneath, you know, the hood of, you know, likely, you know, very complex strategies that they’re deploying at a quantitative level. You know, the a very recent structural element that’s changed also is this huge boom we’re seeing in AI related infrastructure and data centers all around the country. And so the thing that’s very unique there is not only are we seeing the need to finance to a very large dollar amount degree, these huge infrastructure projects, but a lot of the debt needed to finance them are is longer dated debt by very high investment grade quality companies.

And so you’re now seeing also a a slight, pullback or shift in interest from some entities who may be normally buying twenty, thirty year treasury bonds now looking to very high grade long dated, you know, twenty year debt potentially for AI infrastructure projects. And so just the introduction of this long dated, debt for infrastructure has now potentially then caused, buyers to demand, again, a higher yield on the treasury bonds. They’re still buying the treasury bonds, but they demand a slightly higher yield because now there’s this other longer dated high grade competition in the market by way of, some of these, very large scale, infrastructure projects.

So, I mean, I actually find this kind of reassuring to hear you walk through it. It’s like, yes, yields are higher, but there’s pretty understandable kind of reasons behind it. And and the reasons by themselves are, you know, I mean, they’re not necessarily like great news or anything across the board, but it’s not it doesn’t seem to be like a spiraling type of crisis, which has been the flavor of some of the headlines, I think, that we’ve seen about this. And so, David, I’m wondering if you can just kind of tie this up. I mean, what are the key takeaways that, you know, someone that we should have as an investor, you know, someone who’s got, we’ve got most of us have an allocation of some sort to bonds in our portfolio. How should we be thinking about fixed income and making sense of what these rising yields mean for us?

Yeah. Again, I think when you look at the big picture, but also when you dig into what’s going on with some of these drivers, there’s really no area for big alarm at the moment that we’re seeing. And the the levels in yields across the board and the levels of rates across the board are actually well within the normal long term balance of what we’ve seen in the past.

What is what is very different is the fact that we’ve had such an abnormally low interest rate environment for many years following the great recession. So that’s that’s really number one. Number two is that bonds still play a very important role in portfolios when it comes to providing diversification, but also just overall equity balance.

And so especially when you position your portfolios into higher grade bonds, potentially shorter duration, shorter term bonds, they play a very important role still in everyone’s portfolios when we think about the multi asset class framework, we think about longer term strategic allocations. And it’s also important to note that even when bond prices go down a little bit like they have year to date, when those portfolios rebalance, you’re then buying bonds at a better price that have higher yields and those yields then get reinvested. And so it actually, you know, still can work out very well, you know, for for clients that have diversified portfolios longer term.

And then the last piece, you know, which which is always is that, you know, we always expect things to change. So we’re always watching these drivers. We’re always looking for regime change signals, but everything says still stick to the plan. So, you know, as a client or as an investor, you know, the your risk tolerance, your time horizon, you know, the plan that you’ve discussed, you know, with your wealth advisor, you know, there’s no reason right now we see to be deviating from that plan. Stay focused on the fundamentals, and we haven’t really seen, you know, anything that, that causes alarm or need to change that.

David, this has been great. Thank you so much for talking this through with us.

Yeah. Happy to be here.

If you’re already a Mercer Advisors client, don’t hesitate to reach out to your advisor and talk about what you’re seeing and what you’re thinking about. If you’re not a Mercer Advisors client but you’re interested in more information, head to our website, merceradvisors.com, set up a phone call. Thank you so much for being with us today on Market Perspectives.

This presentation by Mercer Global Advisors Incorporated, also known as Mercer Advisors, was intended for general information purposes only. No portion of the presentation serves as the receipt of or as a substitute for personalized investment advice from Mercer Advisors. All expressions of opinion reflect the judgment of the speaker as of the date of recording.