Another dot in the story of higher US rates

Steven Abrahams | January 24, 2025

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.

With 100 bp of Fed cuts since September, conventional wisdom would predict lower rates across most of the Treasury curve. But conventional wisdom hasn’t been working well lately. Most rates instead have moved up, with the 2-year, for instance, up 67 bp and the 10-year up 89 bp. Explanations for the higher rates have included rising expectations for growth, higher volatility and term premium, more tariffs and inflation and more fiscal spending and Treasury supply. Now along comes another intriguing possibility: heavy foreign official selling, which, if it continues, should steepen the curve from short rates out to 10 years.

Foreign central bank holdings tank by $77 billion

A new note from the Centre for Economic Policy Research points to a nearly $77 billion drop in foreign official Treasury holdings in custody at the New York Fed since the Fed started cutting in September (Exhibit 1). Foreign official portfolios include central banks, sovereign wealth funds and others. Most off the drop has come since the US election on November 5. Unfortunately, the Fed’s single weekly number does not show which central banks have reduced holdings or in which maturities. The piece shows that allocations to the foreign repo pool at the Fed have not changed, so overall allocation to US dollar assets has dropped. The reason for the drop is up in the air but could include concern about a range of things from the value of the dollar to a continued rise in rates to vulnerability to having assets seized in any geopolitical conflict with the US.

Exhibit 1: Foreign central bank Treasury holdings drop $77 billion since Sep 18

Source: Federal Reserve H.4.1, Santander US Capital Markets

As foreign central banks have cut Treasury holdings, primary dealers have added. From September 18 to December 25, dealer holdings rose $78 billion, most coming after US elections and closely tracking the timing and magnitude of the drop in the Fed custody numbers (Exhibit 2). Street Treasury balances have since declined. The rising dealer holdings suggest weak demand from other investors, at least over the last quarter of 2024.

Exhibit 2: Primary dealer Treasury holdings rise as central bank holdings fall

Source: Bloomberg, Santander US Capital Markets

The authors of the CEPR note point out that their past work predicts a $100 billion flow in foreign official holdings would move intermediate and long Treasury rates by more than 100 bp—broadly consistent with the recent move. But that estimate is much higher than ones presented in a long series of studies (here and here, for example) that try to estimate the yield impact of foreign flows. Other studies predict a $100 billion flow would change 10-year yields by anywhere from 13 bp at the low end to 68 bp at the high. The authors of the CEPR note argue that their study brings a better analytic approach to a stubbornly difficult problem—explaining changes in a rate driven by multiple, intertwined influences. The wide range of estimates puts a spotlight on how difficult it is to nail this one down.

Another good theory: growth

Rising expectations for growth looks like another good horse in the race to explain recent higher rates. Real 10-year rates—the average clearing level for the supply and demand for money over the next decade—has moved up 59 bp since September, with most of that coming before US elections (Exhibit 3). The rising real rate arguably reflects rising demand from a growing economy, assuming the supply of money will lag rising demand.

Exhibit 3: Real 10-year rates have moved up 59 bp

Source: Bloomberg, Santander US Capital Markets

Volatility doesn’t look like the answer

Implied interest rate volatility could explain the higher rates if more uncertainty about the Fed and other influences led investors to demand more term premium for taking interest rate risk. But implied volatility, at least measured by the MOVE index, rose into the US election and dropped sharply afterwards (Exhibit 4). Rising vol into the election might explain rising rates over that stretch, but rates kept rising even though vol dropped afterwards. Vol doesn’t look like a clean explanation.

Exhibit 4: Implied rate vol rose into elections and fell after while rates kept going

Source: Bloomberg, Santander US Capital Markets

Supply doesn’t look like the answer

Although rising expectations for fiscal deficits and ballooning Treasury supply could explain higher rates, that explanation gets no support from recent swap spreads, where rising supply should widen the gap to SOFR swap rates, all else equal. Spreads to 10-year swaps have barely moved since late September and have actually narrowed since the election (Exhibit 5).

Exhibit 5: Swap spreads signal little change in expected Treasury supply

Source: Bloomberg, Santander US Capital Markets

A blind spot on inflation

Of course, rising inflation expectations could explain higher rates, but that information is hard to come by outside of breakeven rates, or the spread between notes and TIPS. And although 10-year breakevens have moved up 30 bp since the Fed’s first cut, there’s no independent information there.

Focus for now on foreign demand and real rates

Foreign official selling and higher expectations for growth look like the two strongest explanations for the recent rise in longer rates. Other factors are in the background, but these are in the lead. The acceleration in both trends after the US elections suggests they reflect expected changes in US policy on, among things, tariffs, trade and taxes. Tariff and trade policy could raise concerns at foreign official portfolios about holding US dollars, especially if there is risk of a tariff war or other conflict with the US. All of these areas could affect expectations for growth. None of these policies have been set yet and seem to be changing by the day. With them, the outlook for longer rates seems likely to change as well.

On balance, the mix of influences for now seem to lean toward a steeper 2s10s curve. If concern about policy triggered the drop in foreign official appetite, then the new administration has provided plenty of food for thought. The administration has suggested tariffs on Canada, Mexico and China starting February 1, countries that together make up roughly a third of US trade. Whether that is a plan or a negotiating tactic, time will tell. But it seems reasonable that foreign official accounts would want to stay liquid and reduce US dollar exposure while things play out. While the Fed pins down short rates, longer rates could continue rising.

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The view in rates

The Fed and the market have generally agreed for most of this year about where fed funds will end in December. Both see roughly two cuts of 25 bp. But beyond 2025, the market is fading the dot path, with the market pricing funds 37 bp above the dots at the end of 2026 and 90 bp above the dots at the end of 2027.  The market clearly does not believe inflation is dead. Breakeven 2-year inflation is now up 31 bp in January.

With longer rates, the fading appetite of foreign official portfolios and rising real rates keep yields rising. The forces in play there look sensitive to changing US policy on tariffs, trade and taxes, among other things. Policy remains in flux, but the bias seems to higher rates.

With discussions of tariffs, changes in immigration policy and an active battle underway in Congress over federal spending, the range of potential paths next year for the Fed has expanded. Rate volatility still does not look fully priced into options markets, especially for longer tenors.

Other key market levels:

• Fed RRP balances stand at $105 billion as of Friday, down $13 billion in the last week. With RRP at 4.25%, Treasury repo at 4.33% and MBS repo at 4.41%, cash has much better alternatives than RRP.
• Setting on 3-month term SOFR closed Friday at 429 bp, unchanged again on the week.
• Further out the curve, the 2-year note traded Friday at 4.27%, unchanged in the last week. The 10-year note traded at 4.62%, up 1 bp in the last week.
• The Treasury yield curve traded Friday with 2s10s at 35 bp, steeper by 1 bp in the last week. The 5s30s traded Friday at 42 bp, flatter by 1 bp over the same period
• Breakeven 10-year inflation traded Friday at 241 bp, down 1 bp in the last week. The 10-year real rate finished the week at 221 bp, up 2 bp in the last week.

The view in spreads

Implied rate volatility came off a bit in the last week but looks likely to stay high, leaving nominal MBS spreads volatile. Volatility will likely depend on the tariff, immigration and fiscal policies implemented by the new administration. Those seem to be evolving quickly.

The Bloomberg US investment grade corporate bond index OAS traded on Friday at 78 bp, tighter by 2 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 136 bp, unchanged in the last week. Par 30-year MBS TOAS closed Friday at 37 bp, tighter by 4 bp in the last week.

The view in credit

Fundamentals for consumer and most corporate credit continue to look stable. Most investment grade corporate and most consumer balance sheets have fixed-rate funding so falling rates have limited immediate effect. Consumer debt service coverage is roughly at 2019 levels. The rate of serious delinquency in residential mortgages and of loans in foreclosure have barely changed over the last year. Leveraged loans are showing signs of stress, with the combination of payment defaults and liability management exercises, or LMEs, often pursued instead of bankruptcy, back to 2020 post-Covid peaks. If the Fed only eases slowly this year, fewer leveraged companies will be able to outrun interest rates, and signs of stress should increase. LMEs are very opaque transactions, so a material increase could make important parts of the leveraged loan market hard to evaluate.