August has been a pretty tough month for US Treasury bulls (and other rates markets, for that matter), with 10yr yields having spiked higher by 30bps, in very short order. Jerome Powell is due to speak at the Jackson Hole symposium on Friday, where he will deliver a talk on the economic outlook, with the rates move giving increased significance to the content of the speech.
For most of the year, Powell and his FOMC colleagues, have been very consistent in remaining hawkish on the need for further rate rises, and they have succeeded in dragging the market into line, with their “higher for longer” mantra. It’s worth remembering, that as the US regional bank crisis reached its peak approximately 6 months ago, 10yr Treasury yields were 100bps lower. The unwinding of this rally, which tightened financial conditions again, was very much what the Fed wanted to achieve; however, the recent sharp move higher may now encourage a softening of this consistently hawkish tone.
Where Treasury yields will ultimately settle continues to be an interesting debate, and the topic is attracting plenty of headlines given the recent volatility, with a renewed focus on the neutral rate or “r*”. In 2001, current FOMC member and president of the NY Fed, John Williams, wrote a paper that caused renewed interest in the r* topic. He defined it as the “the real short-term interest rate consistent with output converging to potential, where potential is the level of output consistent with stable inflation”. Previously, the nominal neutral rate was estimated to be between 2.5-3%, and indeed Powell commented as far back as July 2022 that rates had reached “a neutral level”. Base rates back then had just reached 2.5%, they are 300bps higher now. It’s probably unlikely that Powell will return to the topic on Friday, although it has been mentioned by a number of Fed officials recently, but in any case, even if r* is moved higher, current short rates are likely to look restrictive.
With 10yr Treasury yields now through their previous highs for this hiking cycle, and above any level seen since before the global financial crisis, they certainly look a lot more attractive now. Real 10 year yields are now also at 2%. As well as offering attractive yield, they also offer a fairly cheap hedge against a harder landing than currently being predicted. Bear in mind that even in the most rosy growth scenario, we are clearly late cycle with many of the recessionary buffers having been removed leaving the economy more vulnerable to an external shock, which is normally what tips an economy into recession. As mentioned, the 10yr yield was 100bps lower when the regional bank cracks were appearing, and the longer conditions remain restrictive, the greater the likelihood of more cracks appearing.
This leads us back to what Powell is likely to say at Jackson Hole. The current market-implied base rate in 12 months’ time is 4.9%, which is above the median dot plot for 2024 year end of 4.625%, suggesting the “higher for longer” message has finally been received. Given the difficult month we are currently enduring for risk markets, as well as rates, Powell may feel he can hit pause on the message for further hikes and higher for longer, potentially allowing him the rare opportunity to be more market friendly this week.