Gael Fichan, Head of Fixed Income at Bank Syz
The US bond market is experiencing increased volatility due to a 60 basis point jump in the 10-year Treasury yield following the September 18, 2024 FOMC meeting. This upward pressure is paralleled by a sharp increase in interest rate volatility and a shift towards higher interest rates. The term premium is positive, indicating a significant change in market dynamics. In this analysis, Fichan explores the key factors behind these developments and considers what will happen ahead of the US election in just one week.
Bond market upheaval: What’s driving it?
Since the Fed’s September meeting, the 10-year Treasury yield has jumped nearly 60 basis points. The rise was driven by better-than-expected U.S. macroeconomic data, commodity price inflation fueled by Chinese stimulus, and central bankers such as Neel Kashkari and Christopher Waller, the This reflects multiple factors at play, including recent comments from Fed policymakers advocating for higher rates.
Increasing political uncertainty is adding to the pressure, particularly the increasing likelihood of a Republican “swamp victory” (president, Senate, and House of Representatives) that could accompany a potential Trump victory. This political backdrop is fueling market anxiety as investors brace for new tax cuts and the possibility of higher federal deficits, which historically contribute to upward pressure on bond yields, particularly term premiums. This is a contributing factor.
Positive term premiums and bond market tensions
Several important factors are driving the spike in U.S. Treasury yields, which are discussed in more detail below.
Reassessment of terminal rates: A hike in terminal rates (essentially the lowest rate expected in the Fed’s current rate cutting cycle) is priced in, influenced by data showing the strength of the U.S. economy. A “soft landing” scenario appears increasingly likely, implying a rise in the “neutral interest rate” (the rate at which the economy neither accelerates nor decelerates). The reassessment would increase the expected final rate from 2.7% to 3.4% within a month, consistent with recent comments from Atlanta Fed President Rafael Bostic, who estimated the neutral rate at 3.0% to 3.5%. Pressure on break-even interest rates: Break-even interest rates, which measure the difference between nominal and real yields and are a proxy for inflation expectations, have been affected by rising geopolitical tensions and China’s economic stimulus. The 10-year break-even rate rose in the past month from 2.05% to 2.32%, moving closer to its 2024 high of 2.4%. Although oil prices have fallen due to lower risks in the Middle East, break-even rates remain high. Rising term premium: The term premium, or the additional yield investors need to own long-term government bonds, has turned positive and reached its highest level in 2024. Term premiums, which have typically been at low levels since the 2008 financial crisis due to liquidity injections, are expected to rise in cross-border capital, with 70% due to fixed income volatility, 10% due to changes in inflation risk, and the remainder due to changes in demand and supply. We believe this is due to changes in dynamics. Interest rate volatility spikes: The MOVE index, a barometer of bond market volatility, hit a one-year high on October 7, leading to the collapse of Silicon Valley banks and the Fed’s 75 basis point interest rate hike in June 2022. exceeded levels seen at the time. This is the first time the one-month option has been extended beyond Election Day, reflecting growing political uncertainty over future yields, MOVE founder Harley Busman said.
What do these ratings reflect?
If the Fed cuts rates two more times by 25 basis points by the end of 2024, as the market expects, the yield curve could steepen by about 70 basis points. This is in line with the current 10-year Treasury yield of about 4.2%, which is close to the historical average of 80 basis points. In particular, the US 10-year Treasury yield has risen by 60 basis points in recent weeks as markets increasingly expect that President Trump will win with Republicans in the House, Senate and House of Representatives. Unlike 2016, when Trump’s surprise election sent 10-year Treasury yields up 80 basis points, this time the market is more prepared and the correction is less sharp but still impactful.
From a valuation perspective, given the current economic cycle, a 10-year bond yield of 4.2% approximates fair value under conditions where a Republican victory seems plausible. Recent repricing pressures on terminal rates appear to be peaking, with break-even rates decoupled from oil prices, which have softened recently. This discrepancy is unusual because break-even points usually reflect movements in the prices of primary commodities such as oil.
A recent report on the impact of the US election on bond markets suggests that President Trump’s inauguration could lead to more aggressive fiscal expansion through significant tax cuts, increased defense spending, and potentially new tariffs. I emphasized that it was expensive. Such policies could increase inflation risks and limit the Fed’s ability to cut interest rates significantly. In this scenario, higher inflation expectations and higher term premiums could cause long-term yields to rise more sharply and the yield curve to steepen further. Fiscal expansion and the potential for trade disruption from tariffs could further accelerate inflation, pushing yields higher as investors seek additional compensation for increased risk.
At this level, additional basis points could be added, justified by a combination of uncertainties surrounding future Treasury supply and expected expansionary fiscal policy. The combination of increased government spending and potential supply-driven inflation risks could put further upward pressure on long-term bond market yields.
conclusion
Recent bond market volatility appears to have already priced in the likely outcome and policy implications of the upcoming US election. This suggests that any potential post-election surge in yields may be subdued and is unlikely to match the intensity of 80 basis points. The surge seen after President Trump’s victory in 2016. Nevertheless, the potential for further yield increases remains, especially if unexpected fiscal or economic developments occur.
Two important factors can cause yields to remain stable or decrease slightly. First, a divided government limits fiscal expansion and makes it difficult to pass major spending measures. Second, weaker-than-expected macroeconomic indicators could prompt a more cautious policy response and delay or reduce expected fiscal reforms, thereby easing upward pressure on yields. There is a possibility.
Without these stabilizing factors, we expect the bond market to remain stable, albeit fragile, around current levels. We remain wary of ‘tail risks’ that could upset this balance, particularly at the long end of the yield curve. A major policy shift or economic surprise could put fresh upward pressure on yields. Given this potential volatility, we maintain a cautious stance on long-term interest rates and are prepared to respond to unexpected developments in the market.
