Multiple Drivers of Bond Market Selloff

10-year yields are up +60bps in the last 6 weeks

In the past 6 weeks, we’ve seen a lot of good news:

1. Macro data have generally been betterthanexpected
2. Equities have hit record high after record high
3. The Fed finally began its rate cut cycle with a 50bps cut late last month

Despite all this good news, we’ve actually seen long-term bonds sell off. 10-year Treasury yields are up +60bps since mid-September to over 4.25%.

10-year yields comprised of inflation expectations and real rates

To understand why, you have to understand what makes up the 10-year Treasury yield.

You can think of it as the sum of:

And the +60bps increase in the 10-year Treasury yield (chart below, black line) is driven by both the inflation (orange line) and real (green line) components.

Inflation expectations increasing on stronger economy, geopolitical tensions, and government spending

10-year inflation expectations are up +20bps (orange line) to 2.3%. There are a few reasons why:

• Rising geopolitical tensions, which could increase energy inflation
• With analysts projecting both Presidential candidates will increase government spending (especially in red wave/blue wave outcomes), expectations are rising that increased government demand will boost inflation
• A stronger economy (next section) sees increased demand, adding to inflation

Real rates rising on a stronger economy and Fed rate cuts reducing recession odds

10-year real rates are up +40bps (green line) to 1.95%. Again, for multiple reasons:

• The Fed’s pivot to rate cuts reduced the risk of recession, meaning higher average economic growth over the next 10 years
• Stronger-than-expected economic data over the last couple months (+254k jobs in September, Services PMI up to 17-month high, better consumer spending, etc) further reduced recession odds
• Expectations of increased government spending (previous section) will add to economic growth

Increasing government debt adds to credit risk, boosting the term premium

There’s also a third component that’s rising – the term premium. That’s the extra yield investors demand for the risk of owning long-term debt rather than rolling over shorter-term debt. And it’s up +45bps (chart below, red line) to 0.2%.

We’re also double counting… because it’s part of the inflation expectations (orange line) and real components (green line).

But it captures something different. The analyst projections for increased government spending, which is boosting inflation expectations and real rates, would also add to the debt pile. Analysts project government debt as a share of GDP will rise 30%-40% over the next 10 years from ~100% now.

That significant growth in debt makes it riskier to hold longer-term debt since there’s greater odds of default.

Falling Fed rates and rising long-term rates are consistent

So even though the Fed has pivoted to cutting (short-term) rates, these other factors mean it’s still consistent with long-term rates rising. With a jobs report out Friday and the election next week, we could see big moves in long-term rates over the next 10 days.

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