Thirty Year Yields Hit 5.34 Percent and the Selling Was Global

What Happened Yesterday

The yield on the thirty year Treasury Note reached 5.34 percent yesterday, the highest level since 2007, while the ten year was close to 4.74 percent. Uncharacteristically, this spike followed neither a meeting of the Federal Reserve, nor the release of any major news that a reporter could latch onto

That absence makes the move unusual. Big moves in Treasury prices are typically the result of a readily apparent catalyst, and there was little reason for sellers to act in concert, except that they did not act in concert with the rest of the world.

This morning, the Treasury announced it would double the size of its bond repo operations, and yields quickly fell back to the familiar range. This is an important detail, because it reveals something about the way the authorities assess the situation, and it is worth exploring both the context and the solution.

The Same Move in Four Countries

The broadest context is provided by what happened elsewhere. The same basic move in long yields was seen in four major economies, even if the details were somewhat different.

In this week alone, the U.S., Germany, France, and Japan have seen their thirty year yields climb substantially. Germany is a deeply conservative economy, while Japan has pursued deliberately expansionary policies for thirty years. This is not a sign of weakness in one country, or even in the developed world as a whole, but in the capacity of long dated lending instruments to serve their traditional role as a hedge against inflation and capital loss.

What a Long Yield Is Made Of

It is helpful to think of a long yield as two variables. Consider a thirty year bond, and separate its yield into two parts. First is the expectation of what short term interest rates will be over the life of the bond, and specifically the average such rate. If you could roll a ten year Treasury note every year for thirty years and earn 4 percent, you would not buy a thirty year bond for 3 percent, if only for the opportunity cost of your capital. Long yields must always exceed the market expectation of future short rates, or no one would buy them.

The second component is known as the term premium. This is the additional return that investors demand for locking up their money for a long period of time, and specifically for the risk that the value of that money will decrease due to inflation in the meantime. Inflation is a risk for any future income stream, including bonds. If rates rise, the bond becomes less valuable, not only because of the opportunity cost but because the income stream itself is discounted. Worse, an investor with an urgent need for cash may be forced to sell at any price, depending on prevailing conditions. The term premium reflects the risk of all of those outcomes. Unlike the first component, it is not directly observed, and it has tended to be overlooked, to the dismay of monetary policymakers.

Why This Is Not a Federal Reserve Story

That leads to this most important distinction. The first component is essentially within the gift of the Federal Reserve, and specifically the Federal Open Market Committee. The policy rate has been between 3.5 and 3.75 percent throughout the year, with three dissenting votes in favor of a rate hike at the July meeting. With the exception of a possible shift later this year, no one is forecasting a tightening cycle. Taken together, that means that the expectations of future short rates are unlikely to contribute much to the value of a thirty year Treasury, and that something else, namely the term premium, must be responsible.

The practical implication is that the Federal Reserve is not the agency best positioned to respond to this development. Its tools are largely limited to the first component, and particularly the ability to raise or lower the federal funds rate. In isolation, that would be sufficient, but in recent months, forward guidance from the FOMC has tended to suggest that the committee anticipates a dovish pivot, perhaps as early as next year. Attempts to reduce the term premium by cutting the federal funds rate would have the perverse effect of making the central bank appear more tolerant of inflation, which would itself increase the premium.

Why the Damage Concentrates at the Long End

The damage inflicted by rising yields is not distributed evenly across the yield curve, due to a characteristic of bonds known as duration. Bonds with longer maturities are more sensitive to changes in yields, and therefore have greater durations.

For a rough approximation, use the rule of thumb that the percentage change in a bond’s price will be roughly equal to the change in yields multiplied by the duration. For a two year note, the duration is close to two, which means that a one percentage point rise in yields will decrease the price of the note by approximately 2 percent. For a thirty year note with a duration of twenty, the same change in yields will decrease the price by approximately twenty percent. This is an important distinction, precisely because bonds are frequently bought and sold at prices far below par, particularly when held by institutional investors.

A bond market selloff is a systemic event, in part because government bonds are effectively the cash of the financial system, and in part because large institutional investors tend to hold them in similarly large positions. In other words, a government bond is a claim on the issuer’s credit, not an equity instrument or a derivative with a defined payoff schedule. Duration risk is different from credit risk, but the two are too often conflated for duration to serve as a reliable guide to value.

The Mechanism That Makes It Feed On Itself

The self reinforcing mechanism begins when bonds are purchased with borrowed money. When the value of the collateral decreases, the lending institution demands additional deposits from the borrower before re-lending the money. The easiest way for the borrower to raise additional funds is by selling the very bonds that are serving as collateral, which causes their price to fall further, allowing the lender to demand even more deposits. This is a self reinforcing mechanism, and the selling pressure is not necessarily the result of any change in fundamentals, but more often the result of a change in leverage policy.

The same dynamic tends to occur at the level of individual institutions with long dated liabilities. Many investors buy long dated bonds in order to fund liabilities that they expect to occur much farther in the future. As a result, they are less concerned with the value of bonds on a day to day basis, and more concerned with their duration. A jump in yields will cause bond prices to fall, and the failure to adjust the duration of one’s portfolio will lead to selling in order to reduce that duration. That is a mechanical response to a shift in yields, and it is useful to remember that most institutional investors have far more buying power than selling power at any given moment. The combination tends to cause sharp drops when a market turns.

There is a final dynamic, particular to long bonds, that tends to exacerbate moves in either direction. Many investors buy bonds with the intention of holding them until maturity, which is especially common among pension funds and insurance companies. During the period between purchase and sale, these investors are subject to the same risks and opportunities as any other bond owner, but they are constrained by their desire to hold until maturity. In other words, they have little flexibility in response to a change in yields. If their liabilities dictate that they sell, they sell, and if their assets dictate that they hold, they hold. The ability of such investors to participate in the market depends on their access to financing, which is why long bonds are particularly sensitive to changes in funding costs.

How You Tell a Selloff From a Breakdown

The distinction between a selloff and a market breakdown is an important one, as the appropriate response differs dramatically depending on which environment prevails. Lower prices are not a malfunction, but rather a sign that the market has done its job, pricing securities according to their fundamentals. As such, no policymaker wishes to see prices remain permanently too high, but a selloff will often do the opposite, forcing prices lower and encouraging buyers to enter the market.

A breakdown is different in that it reflects institutional impediments to trading, and it is typically signaled by widening bid-ask spreads, a reduction in market depth, or a failure to maintain consistent relative values between similar assets. The latter is frequently the most telling sign in a government bond market, where otherwise identical thirty year bonds will have significantly different yields based on liquidity considerations. One thirty year Treasury will have a yield significantly higher than another, simply because one is newly issued while the other is held by a buyer seeking to realize gains. The difference in yield swells, creating a risk that holders of the lower yielding bonds will be unable to sell at a reasonable price.

In 2022, the breakdown in Britain’s long bond market led to a self reinforcing selling spiral among pension funds. The dynamics were particular to Britain’s system, but the basic mechanism of a dysfunctional market in search of an exit is instructive. No market is perfectly robust, and few have the capacity to absorb large scale buying or selling without disruption to the securities in question. In this respect, a market breakdown is similar to a bank run in reverse.

What the Treasury Did This Morning

This morning’s announcement, which stated that the Treasury would double the size of its repo operations, is more significant than it may appear. First, and most importantly, it suggests that the Treasury recognizes the risk of a market malfunction, and it has acted to mitigate that risk. A repo is a repurchase agreement in which the Treasury buys bonds from dealers on its balance sheet, and it has the effect of reducing selling pressure among security holders. The announcement signals concern on the part of the Treasury, but it also has practical consequences, in that it facilitates selling by buyers who wish to liquidate their positions without depressing prices.

The announcement should not be seen as an attempt to reduce the overall supply of bonds, since the practice of buying bonds back only to sell them again tends to have little impact on total issuance volume. Repurchase agreements exist to manage liquidity by reducing the supply of any given issue. Older bonds tend to have less liquidity than newer bonds, simply by virtue of having been issued first. In times of stress, those bonds are more difficult to sell, which means that holders of those bonds are more likely to sell at depressed prices. By announcing that it will always be prepared to buy back older issues, the Treasury allows holders of those issues to sell at a reasonable price, relieving some of the pressure on the market as a whole.

What a Buyback Cannot Do

It is worth being clear about the limitations of a buyback. In particular, it is crucial to remember that the Treasury has not done anything to address the fundamental causes of the term premium, which remain rooted in inflation and in the issuance schedule. Buyers may have found a more liquid market, but they have not received any assurance that either will change.

It is tempting to interpret the reduction in yields this morning as evidence that the term premium has disappeared, but there is little reason to believe that it has been eliminated entirely. The announcement has reduced dysfunction without addressing the underlying cause, and the most useful way to think about it is as a reduction in water pressure, rather than a reduction in water volume. If the former is the result of a burst pipe in the plumbing system, the immediate response is to fix the leak rather than the tap. Similarly, the buyback reduces immediate stress without altering the longer term dynamics.

The announcement by the Treasury is nonetheless worth noting, as it represents a tacit admission of the severity of the situation. Authorities rarely alter the size of such operations on a whim, and the decision to double the size represents a recognition that the situation warranted intervention.

What Would Actually Stabilize the Long End

There are three factors that would reduce the term premium, and none of them require a change in market structure. First, the most direct way to reduce the cost of duration is to reduce inflation. Much of the value of a long dated bond derives from the protection it provides against inflation over the life of the issue, and thirty years is a long time to be exposed to the ravages of rising prices. Fortunately for investors, central banks have spent the last five years targeting precisely that, with only mixed success. Core inflation has fallen to 2.5 percent, but it has spent the same amount of time hovering around and occasionally exceeding 3 percent. A period of disinflation would be far more valuable than a technical adjustment to the bond market.

The second factor is less certain, but just as important. Policymakers would reduce the term premium by reducing the Treasury’s overall borrowing needs. Lower issuance means less supply, which ought to reduce yields, particularly if the reduction occurs at the long end. The third component requires a return to buyers that do not care about price discovery, and that tends to take time. The central bank and foreign official investors have bought bonds for the past fifteen years without demanding much in the way of compensation, and their replacement has been less willing to offer the same support.

What to Watch Now

Looking ahead, auction results are the best guide. When the Treasury auctions a new issue, watch the yield at which it clears relative to the market expectations both immediately prior to the auction and at the end of the following day. Watch the ratio of bidders to total quantity offered, and determine whether the market has sufficient appetite for new supply. Watch the yield curve, and in particular the spread between the long end and the short end. A rising yield curve is one in which long yields rise faster than short yields, which is what happened this week. Such a move reflects a term premium, and a change in that premium represents a shift in the outlook for inflation. However, if short yields begin to rise in concert with long yields, it will be a signal that the market has changed its outlook for the Federal Reserve, and that the policymakers are no longer seen as credible inflation fighters.

The Bottom Line

A thirty year yield of 5.34 percent, coming simultaneously with jumps in yields in France, Germany, and Japan, is not a uniquely American problem, but one that reflects a failure to price long dated bonds appropriately. The technical explanation focuses on the term premium, but that is a proxy for a number of different concerns. The most immediate concern is that inflation has remained too high for too long, but the longer term concern reflects a combination of reduced credibility and a reduction in the capacity to absorb large scale purchases. The response by the Treasury to the dysfunction was entirely appropriate, in that it addressed the liquidity problems without attempting to disguise the causes of the malaise. In this week’s dysfunction, the tools were limited but not absent, and the solutions were narrow but not nonexistent.