Here’s how the US 10yr could re-test 3%

We called a peak for market rates when the US 10yr hit 3.5%, noting that the richening in the 5yr part of the curve was consistent with a falling rates environment and / or a Fed that was approaching the end of the rate hike cycle. Both remain true. We also noted a re-visit to prior highs was entirely possible, but there has barely been a sniff of that. The peak has been followed by a relentless fall in yields, one that now sees us knocking on the door of 2.5% for the 10yr.

The issues here are numerous. The first question is to what extent can the Federal Reserve push against this and continue to deliver rate hikes. The part answer is the Fed is far from done. But then the extended second question is to what extent can market yields then continue to test the downside if the Fed is not done. And then the implicated third question is whether the Fed could be influenced by dramatic falls in market rates.

Right now the US 10yr is a mere 20bp above the effective fed funds rate. If the 10yr remains here and the Fed hikes in September (we think by 50bp), the 10yr will then trade some 30bp through the funds rate. This is not unusual at this phase of the rate hiking cycle. History shows that the 10yr can trade dramatically through the funds rate. In fact back in the heady 1970’s and 1980’s it managed to trade some 4-8% through. But that was when rates were up at 10-15%.

Taking a more modern period, back to the 1990’s, we find that the 10yr in the extreme has managed to trade 150bp through the funds rate (apart from a few one-off spikes). That, as a stand-alone fact, would suggest that there is no real issue with the Fed continuing to hike the funds rate as market rates fall. For example, it suggests that the US 10yr yield could fall towards 2% while the Fed hikes to above 3.5%, resulting in a repeat extreme spread of 150bp.

However there is one important nuance here. When the 10yr breaks below the funds rate, the funds rate itself tends to have peaked, or at least be very close to one. It can be just about to peak, or can actually have peaked. But there is no example in modern times of a large negative gap opening up between the 10yr yield and the funds rate that has been led by the funds rate. It is always led by the 10yr yield.

To crystallize this point, take a look at the scene below; back at the bursting of the dot-com bubble, a period that has many similarities to the current phase (albeit with just as many differences). The chart on the left shows the moment that the 10yr broke below the fed funds rate, and the chart on the right then shows the follow-through where the 10yr continues to trade further and further through the fed funds rate. There was one further hike, but that was then the peak, the 10yr traded 25bp through fed funds before the peak, but no more. After the peak was in, the 10yr really pushed through the funds rate (to 150bp in the extreme), and culminated in rate cuts down the line.

Granted this is just one cycle example, but if you whip out your magnifying glass and apply it to the larger graph above you will find that this is pretty typical of what has happened at virtually every cycle change.

Furthermore, there is no modern example of getting to these extremes where the Fed has pushed against the market and gone ahead and hiked as market rates are falling, in particular when the 10yr is actualy through the funds rate. There are some examples of the Fed getting one more hike in as the 10yr trades through the funds rate, but that is 50bp through at the very extreme (and even that is unusual). The other 100bp is coming from falls in the 10yr yield (not from follow-through rate hikes).

This suggests that it would be unprecedented for the Fed to continue to hike the funds rate should market rates continue to fall from here. So something must give. Either market rates have overdone it to the downside and need to back up, or the Fed needs to start winding lower rate hike ambitions.

Or there is another option, where the Fed chooses to outright sell bonds to the market in an acceleration of its quantitative tightening agenda. An extreme option, but one that is there. Let's park that for now, but watch it come on to the table should the Fed really believe it needs to do more as market rates fall.

Our view? We think the Fed still has a rate hiking job to do. Moreover, we think the Fed thinks the Fed has a rate hiking job to do. Chair Powell termed the current funds rate at just short of 2.5% as being the "neutral" rate. That alone suggests there is a job to be done, with we think at least another 1% is needed on top of that. For that to happen, the US 10yr needs to steer clear of a break below 2.5%. In fact, the Fed might be happier if it managed to claw it's way back up towards a 3% handle again.