7 July 2023

The two-year Treasury yield exceeded 5% last March, reaching a level not seen since June 2007, before the global financial crisis. In the 21st century, it was only the 65th day that the two-year yield had traded above 5%. Today, we are close to 5%, with a two-year yield at 4.98%. This is unusual and signifies that the rate peak has not yet been reached. Meanwhile, the 10-year yield stands around 4% and has yet to match its 2022 high of around 4.24%.

The trigger for the surge in Treasury yields came from stronger-than-expected ADP data on private sector employment, which once again raised bets that the Federal Reserve may not slow down its pace of monetary tightening as inflation proves to be more persistent. The U.S. economy created double the expected jobs in June, adding half a million.

These are not the only figures suggesting the economy is more robust than anticipated. The latest data on jobless claims show no increase in layoffs. There has also been the usual bump in the JOLTS (Job Openings and Labor Turnover Survey). The indicator showed reduced job vacancies, suggesting less pressure on employers to offer higher wages to attract workers. However, this decline is slower than one might have hoped, indicating that there are still over 1.5 job openings for every unemployed person. In short, it is an ideal time to seek employment and negotiate a higher salary.

Other indicators point to a potential decrease in inflation. The non-manufacturing ISM survey of supply managers suggested that the services sector is in better shape than expected. However, the proportion of purchasing managers complaining about high prices in both services and manufacturing has decreased. These surveys have been excellent leading inflation indicators, and they now suggest that price pressures are declining significantly.

Another significant change has occurred. Despite a unanimous decision to leave policy unchanged last month after ten consecutive rate hikes, the FOMC is now divided. Lorie Logan, President of the Dallas Fed, highlighted this in a speech, stating that a rate hike at the June meeting would have been entirely appropriate. 

Meanwhile, the market is almost entirely pricing in a quarter-point hike by July 26th while showing an increasing probability of another hike by year-end. So far, the market has consistently underestimated the inflation trajectory and the critical interest rate path. A rate hike by the Fed in July is highly likely, and with the recent employment data, the door is open for another hike in September. 

A combination of factors has converged to create a consensus that rates will need to rise further. After over a decade of easy money, we have developed bad habits, with a Fed attentive to investor whims, injecting massive liquidity into the system and smoothing economic cycles.

The consequences of this new paradigm are immense for the real economy and financial markets. A higher cost of credit will impact myriad other decisions in the economy. Bond yields are the cornerstone of stock valuation, forming the basis for investment decisions for most investors. All asset classes will experiment a big bang and a considerable level of volatility.

Indeed, in the short term, we could experience a temporary decline in rates. In 2024, the Fed could lower rates in the second half of the year to address a slowdown in the U.S. economy. However, it is unlikely to be a decrease of 100 bps, as shown in the June DOT plot. Many converging forces argue for higher long-term rates:

• Costly energy transition
• Rising commodity prices
• Strategic reshoring of entire sectors of the economy
• The end of globalization
• An inevitable trade war between the two global powers
• Its corollary of unstable geopolitics

The world has changed, and financial markets must prepare for a new reality.