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10-Year Yields Hit Frothy Heights: Time to Boost Bond Allocations as Peak Nears?

By James PicernoBondsOct 17, 2023 07:47AM ET
www.investing.com/analysis/10year-yields-hit-frothy-heights-time-to-boost-bond-allocations-as-peak-nears-200642780
10-Year Yields Hit Frothy Heights: Time to Boost Bond Allocations as Peak Nears?
By James Picerno   |  Oct 17, 2023 07:47AM ET
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The US 10-year Treasury yield continues to rise, pushing ever higher above CapitalSpectator.com’s “fair-value” estimate, which is based on averaging three models. The trend highlights the limitations of models, at least in the short, for estimating near-term changes in bond yields. But reviewing the recent divergence reminds us that the current spread, although extreme by the standards of recent years, isn’t unprecedented.

The 10-year yield in September rose above 4% (black line in chart below) for the first time since 2008, based on monthly data, which is used in our modeling. By contrast, the average fair-value estimate was essentially unchanged at 2.83% (red line), slightly higher than the previous month.

US 10-Yr Yield vs Avg. of 3 Fair Value Model Estimates
US 10-Yr Yield vs Avg. of 3 Fair Value Model Estimates

Reviewing the market yield less fair-value estimate emphasizes the extreme degree of divergence in recent history. The September 10-year rate was 1.56 percentage points above the average fair value, the highest spread since 1994.

US 10-Yr Yield less Avg. Fair Value Estimates
US 10-Yr Yield less Avg. Fair Value Estimates

What’s Driving the Rise in Interest Rates?

Several explanations are popular, including the rise in the term premium:

“The compensation that investors require for bearing the risk that interest rates may change over the life of the bond,” per the New York Fed’s definition.

Some analysts advise that the surge in supply relative to demand for Treasuries is a related factor to the jump in yields (and the commensurate decline in bond prices).

The Economist reports:

“From January to September alone it raised a whopping $1.7 trillion (7.5% of GDP) from markets, up by almost 80% over the same period in 2022, in part because tax revenues have fallen. At the same time, the Fed has been shrinking its portfolio of long-dated Treasuries.”

Alternative theories range from rising doubts about America’s creditworthiness to fears that inflation will stay higher for longer and so the Federal Reserve will be forced to continue lifting interest rates.

Whatever the explanation, the market is pricing the 10-year yield at what appears to be a lofty and arguably unsustainable level. Skeptics can rightly counter that the inputs to our models may not fully capture current events.

At the same time, the spread chart above suggests that the current divergence isn’t unprecedented – far from it. At one point in the early 1980s, the spread briefly topped 3 percentage points — well above the current level.

The spread is now at the 95th percentile, based on history since 1980. That implies that we’re near the peak. The caveat is that events in the months ahead will break precedent and we’re facing an outlier event.

Conclusion

Never say never, but the statistical odds look increasingly favorable for guesstimating that a yield peak is near. In turn, that suggests it’s timely to lift allocations to bonds – especially if current weights are below strategic targets.

At the same time, managing expectations is critical these days. Momentum, after all, has dominated modeling recently and that trend could continue for the foreseeable future.

The spread rise will end eventually, but the uncertainty of when, and why, remains as thick as ever.

10-Year Yields Hit Frothy Heights: Time to Boost Bond Allocations as Peak Nears?
 

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10-Year Yields Hit Frothy Heights: Time to Boost Bond Allocations as Peak Nears?

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Comments (5)
Maria Kenny
Maria Kenny Oct 18, 2023 1:59AM ET
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Don't buy yet or plan to loose 20%
Robert Dugger
Robert Dugger Oct 17, 2023 12:53PM ET
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T bond rates will peak when world net savings (NS) begins rising. World NS is the surplus available in financial markets to fund private and public investment and consumption globally. There are supply and demand curves for NS. World Bank NS data show where demand and supply intersected in years past. The interest rate at which supply intersects demand is the “savings-market clearing rate” (SMC rate).  Increases in NS supply relative to NS demand drive SMC rates down -- markets leverage up and bubbles expand. Think early 2000s.  Decreases in supply relative to demand drive SMC rates up -- liquidity tightens, economies contract. This is what is happening now across all asset classes. Asset managers first pullout of weaker less liquid stocks and corporate bonds, and from less liquid and less creditworthy government debt. The SMC rate is rarely discussed as an explicit market rate. , though broad risk factors, like culture, governance, political stability, demographics, and military strength.
Gonzalo Ribeiro
Gonzalo Ribeiro Oct 17, 2023 12:34PM ET
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Bond yields fell for 40 straight years since 1980 until 2020. Nothing lasts forever
Robert Dugger
Robert Dugger Oct 17, 2023 12:23PM ET
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To understand US bond rates, we need to think globally. World net savings is the surplus available in markets to fund private and public investment and consumption globally. World Bank data shows global net savings (gross savings less capital depreciation) topped out nominally in 2011 and thereafter trended sideways and has been falling recently due mainly to China's failure to recover.  Once net savings ceased rising, growth worldwide could only occur by leveraging up available net savings more than ever before. As leverage rose post GFC and fiscal sustainability deteriorated, world asset managers first withdrew from weaker less liquid stocks and corporate bonds, and from less liquid and less creditworthy government debt. As a result most recently, all but the largest large-cap stocks fell, and weaker currencies fell, making the dollar rise. Also, because the absolute volume of savings was not sufficient to fund government debt issuance, bond rates rose everywhere including in the US.
Richie Berg
Richie Berg Oct 17, 2023 9:35AM ET
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Bond yield will normalize to a positive yield curve. This will not happen by FED lowering the front end. It will happen because the long end will continue drifting up.
Min Chang
Min Chang Oct 17, 2023 9:35AM ET
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Please elaborate? What will cause the long term rates to continue going up?
go si
go si Oct 17, 2023 9:35AM ET
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Min Chang unsustainable US debt
 
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