Higher Neutral-Rate Expectations Show Why Treasuries Hugging 5%

By Ven Ram, Bloomberg markets live reporter and strategist

What happens when ever-widening deficits, resilient demand in the economy and expectations that interest rates will continue to stay aloft collide with one another?

Higher Treasury yields on longer-dated maturities, that’s what.

While this week is punctuated by several central bank meetings, the US Treasury Department will also lay out its plans for new bond sales.

That road map matters more against a backdrop where the fiscal deficit doubled in the year through September to just above $2 trillion. The economy has taken it all in its stride, with growth in the third quarter coming in at almost 5%, well more than twice the pace seen in the second.

Meanwhile, inflation expectations for the next 12 months have now accelerated past 4%.

That’s a pretty heady mix, so it isn’t surprising that readers in the latest MLIV Pulse survey reckon that the US neutral rate - a sort of nirvana where the economy is at full employment without stoking inflation - has doubled to at least 100 basis points from pre-pandemic levels. Which is why 10-year Treasury yields haven’t really pulled back from 5% despite all the tensions in the Middle East. So much so that the median of MLIV readers is for the 10-year yield to settle around 5% by the end of this year.

While that seems entirely plausible, there may be upside risk lurking to yields even beyond, should the Federal Reserve be compelled to tighten policy further to get inflation back to target. While we were in a period of disinflation through the first half of the year, that hasn’t quite been the case in the second. Problem is, the Fed doesn’t quite have any other tool apart from interest rates to get that down.

Given how restrictive its policy rate is, the central bank may well decide to wait and watch for a while more, but those stellar growth numbers from the third quarter may just make policymakers less wary of doing more eventually.