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Investment Strategy
by Larry Adam
Chief Investment Officer, Private Client Group

What’s driving the recent surge in bond yields?

November 15, 2024

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Key Takeaways

• Treasury yields rise as recent growth scare subsides
• Yields are compelling after the latest rate move
• Higher rates could lead to an equity market pullback

Wait, what? The Fed cut interest rates and bond yields went up, not down. Yes, you read that right. While counterintuitive, that is exactly what has transpired since the last FOMC meeting—with the 10-year Treasury yield moving in the opposite direction of the federal funds rate, climbing to a four-month high of 4.47% despite the Federal Reserve cutting interest rates by 75 bps over their last two meetings. Unusual—yes. Unprecedented—no. Yields are largely following the 1995 playbook (the last soft landing for the US economy)—climbing after the Fed’s initial rate cut; but resuming their downtrend as the Fed’s easing cycle continued. While the recent rise in yields has been swift, we have not changed our view that Treasury yields can move lower in 2025 as growth moderates, inflation eases, and the Fed cuts rates further. Below we discuss what’s behind the recent surge in bond yields and what implications, if any, it has for the economy and the financial markets:

Why Are Bond Yields Rising? | While the Federal Reserve has cut rates a total of 75 bps since September, bond yields have surged. In fact, the 10-year Treasury is now 85 bps higher—including 18 bps higher following last week’s election. Here’s what has been driving the move:

• Growth Scare Is Over—Economic data has steadily improved after a brief growth scare earlier in the year. Fears that the economy may be rapidly weakening after the unemployment rate ticked up to a 3-year high of 4.3% in July have subsided as recent data suggests the economy has regained momentum. Case in point: 3Q24 GDP climbed at a 2.8% pace, job growth remains healthy, consumers are still spending, and the stock market is making new highs. In fact, the Citi Economic Surprise index has climbed from a summertime low of -47.5 to a seven-month high of 38.7 after turning positive just six weeks ago. The economy’s rebound caught the market offsides as expectations were leaning towards aggressive Fed rate cuts over the next year. Treasury yields have moved higher as the market unwinds its overly optimistic rate cut expectations—with a total of just three rate cuts expected between now and year-end 2025.
• Policy Uncertainty Picks Up—Election uncertainty is now behind us, but policy uncertainty has ramped up—with the market increasingly focused on the 4 T’s—tariffs, trade wars, taxes and trillion-dollar deficits. The Republican’s sweep has amplified the bond market’s concerns as President-Elect Trump’s policy initiatives that are perceived as inflationary could widen the already growing federal budget deficit. And with the explosion in debt, which has risen 4x since just before the Great Financial Crisis and the cost of servicing the debt running at a nearly $900 billion annual pace (consuming ~15% of revenue), the market has pushed interest rates higher (the 10-year Treasury yield up as much as ~18 bps since the election), factoring in higher debt, deficits and Treasury issuance along with a potentially less accommodative Fed.

Implications For The Economy And Financial Markets | While interest rates have primarily risen in response to the economy’s growth rebound, below we discuss what implications the rate move may have on the economy and financial markets going forward:

• Economy—While it is too soon to see the economic impact of the recent backup in rates, the interest rate sensitive sectors of the economy are likely to come under pressure again if interest rates remain elevated. With mortgage rates now back above the psychological 7% level (for the first time in four months), small business loan rates above 10% (the highest level since 2000), and auto loan rates and the average interest rate on credit cards still elevated (and likely to further weigh on spending), economic activity will likely slow again. That’s because elevated interest rates act as a “self-correcting” mechanism for these sectors of the economy. And as growth moderates and inflation gradually slides back to 2.0%, the Fed can continue to dial back its policy restraint in the months ahead.
• Bond Market—Bond yields typically fall during Fed easing cycles. However, we have cautioned that the longer-term fiscal challenges could keep longer-maturity yields elevated relative to the historical pattern during this easing cycle. While we have not changed our longer-term view that the 10-year Treasury yield can grind lower towards 4% as growth and inflation moderate in 2025—the direction of travel is unlikely to be in a straight line. In fact, the 10-year Treasury yield’s average calendar year range over the last 10 years is 1.25%, so the volatility we are currently seeing is not that unusual. But it provides a compelling opportunity to lock in higher rates as the Fed remains on a path to return policy rates to a more neutral setting. However, a sustained move back to 3.6% on the 10-year is unlikely without another growth scare.
• Equities—With valuations (S&P 500 last 12 months P/E: 25x) at the highest level since the early 2000s ex-the COVID environment, the market has a lot of good news priced in and is susceptible to periods of volatility. Historically, there has been an inverse relationship between equity valuations and interest rates—as elevated rates can reduce the attractiveness of equities relative to bonds. Up until now, the markets have looked past the rise in rates—with the S&P 500 up 6% since 10-year yields bottomed two months ago. However, if the 10-year Treasury yield breaches the 4.5% level, the equity market could come under pressure and lead to a near-term pullback. But as long as the upward trajectory for earnings remains intact and the economy achieves a soft landing, the S&P 500 should continue to move higher longer-term.

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