The Big Idea

A bullish case for longer rates

Steven Abrahams | July 19, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The link between Fed policy and short rates is pretty direct, but the Fed also has surprising pull on longer rates as well. With Fed dots penciling in more than 120 bp of easing by the end of 2025 and funds futures anticipating more than 170 bp, longer rates are likely coming down. History suggests a drop in 10-year yields of more than 50 bp from current levels if dots get realized through 2025 and more than 70 bp if futures get realized, although current circumstances suggest slightly smaller moves. Nevertheless, the drop in longer rates is still likely to exceed current implied forward rates.

Fed dots project fed funds will drop from their current 5.33% rate to 4.12% by the end of 2025 while futures expect a 3.62% rate, although liquidity in the futures contracts is thin. In either case, Fed projections and futures look for an aggressive drop in policy rates over the next 18 months on the way back to neutral. Of course, both dots and futures assume inflation returns to the Fed’s 2% target.

It is no surprise that short rates respond to Fed policy, but longer rates historically have responded strongly to changes in expected Fed policy over periods as short as three months. Since 1990, for instance, a 100 bp change in 3-month Treasury bill rates has come with an average 42 bp change in 10-year note rates (Exhibit 1).

Exhibit 1: Since at least 1990, a 100 bp change in 3-month bill yields comes with an average 42 bp change in 10-year note yields

Note: The data shows the slope of a rolling 5-year regression of monthly changes in 10-year Treasury note yields on monthly changes in 3-month Treasury bill yields along with the average slope from January 1990 through June 2024.
Source: Bloomberg, Santander US Capital Markets

That’s a bit of a puzzle. Long rates in theory should price to the path of fed funds over the entire life of the instrument—10 years in the case of a 10-year note—not just the next few months. That path should compensate for inflation and the real rate of interest. And that suggests investors would price based on the Fed’s current neutral fed funds rate of 2.80%. With 10-year rates currently at 4.24%, that clearly is not the case.

Multiple studies (such as here and here) show clear and significant sensitivity of long rates to realized changes in Fed policy. Theory may say investors take the long view for longer rates, but practice says investors give extraordinary weight to information about the very short run. In other words, don’t tell me, investors say, show me. If the Fed consequently begins delivering on the 121 bp of cuts suggested by the dots through 2025, history argues 10-year rates should drop by more than 50 bp. From the current 4.24%, 10-year rates would drop to 3.74%. If futures turn out to be right and funds drop by 171 bp, history would argue 10-year rates should drop by more than 70 bp. In that case, 10-year rates would drop to 3.54%

Of course, yields on 10-year notes depend on more than just changing expectations for Fed policy over the next three months, and those other factors mean longer rates do not always move predictably with short rates. Other important considerations include:

Expected inflation, for which investors need compensation
Expected growth, which determines the real rate of interest
Expected volatility of interest rates, which influences term premiums
Supply, which affects absolute yields
Demand, especially from foreign central banks and the Fed

When central banks especially in Asia built significant foreign currency reserves and invested much of it in US Treasury debt during the 2000s, for example, 10-year yields moved only slightly despite 425 bp of Fed hikes from mid-2004 to mid-2006. That left the marginal response of 10-year yields to changes in short rates at nearly zero. Marginal sensitivity also swung over a wide range during the 2013 taper tantrum, as uncertainty about Fed QE led to wide swings in expected Fed demand for longer Treasury debt.

Supply and demand today argue for higher rates than implied by the simple relationship between short rates and 10-year yields. When it comes to supply, US federal deficits have trended steadily higher since the late 1990s, and neither party is campaigning these days on fiscal discipline. When it comes to demand, the Fed and some of the largest foreign central bank holders of Treasury debt are steadily reducing exposure. Rising supply and softening demand point to higher yields

If the Fed delivers on dots through 2025, it is reasonable to expect 2-year Treasury yields to drop below 4.0% depending on expected further cuts and for 10-year yields—considering both Fed policy and supply and demand—to settle between 3.75% and 4.00%. That is a more bullish scenario for longer maturities than implied by current forward Treasury rates, which put the 2-year note at the end of 2025 around 4.0% and the 10-year note near 4.25%. Forward rates imply the 10-year yield will show no response to Fed cuts, which seems implausible. As a result, position for 10-year notes to rally further and for the yield curve to be flatter than implied by current forward rates.

* * *

The view in rates

As of the Friday close, fed funds futures for a second week price in 64 bp of easing this year. The market sees a 96% chance of a cut in September and an 86% chance of December. The Fed has said it will need to see several months of benign inflation readings, and the May and June reports on core CPI put the Fed on the cusp. If July comes in below 0.2% month-over-month, that could set up the Fed for a September cut. The report for July comes out August 14.

Other key market levels:

Fed RRP balances closed Friday at $380 billion. RRP balances have bounced between $400 billion and $500 billion since the start of March, so the latest reading drops below the range.
Setting on 3-month term SOFR closed Friday at 528 bp, down 1 bp in the last week.
Further out the curve, the 2-year note closed Friday at 4.51%, up 6 bp in the last week. The 10-year note closed at 4.24%, also up 6 bp in the last week.
The Treasury yield curve closed Friday afternoon with 2s10s at -27, unchanged in the last week. The 5s30s closed Friday at 28 bp, flatter by 1 bp over the same period
Breakeven 10-year inflation traded Friday at 230 bp, up 6 bp in the last week. The 10-year real rate finished the week at 194 bp, unchanged in the last week.

The view in spreads

Implied rate volatility has come off a recent peak but held roughly steady. Credit still has momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risky and riskless assets.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 91 bp, wider by 1 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 144 bp, wider by 7 bp on the week. Par 30-year MBS TOAS closed Friday at 35 bp, tighter by 6 bp on the week. Both nominal and option-adjusted spreads on MBS look rich but likely to remain steady on low supply and low demand.

The view in credit

Higher interest rate should raise concerns about the credit quality of the most leveraged corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income, although the pace of income gains has slowed this year. Consumer delinquencies show no clear signs of stress, with most metrics renormalizing back to late 2019 levels. Auto loans show rising delinquencies that have as much to do with the price of used cars as it does the consumer balance sheet. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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