Treasury Secretary Scott Bessent’s announcement that the US Treasury would buy long dated US Treasury bonds as a means to place a limit on how high these rates can rise (and how quickly) has pitted the might of the US Treasury against a myriad of market forces. These forces, from the nebulous and scarry sounding “bond vigilantes” to the funding needs of deficit financing by the US government itself (as well as other developed economies), to the inflation-nudging oil prices as a result of geopolitical developments in the Straight of Hormuz and Ukraine/Russia, and the capital hungry companies investing billions of dollars in AI infrastructure and other high growth potential tech companies (we’re talking about you SpaceX), are combining to be a formidable foe to the Secretary Bessent and Treasury.
After decades-long management of the yield curve by the Federal Reserve and Treasury (starting with the post financial crisis era of 2008), the increase in yields which started during the Covid lock-down period was a welcome reset of the financial markets, with the US 10 Year yield finally surpassing its post-financial crisis ceiling of around 3%. After all, in a world of free-flowing capital, the shape of the yield curve gives investors and risk-takers the most honest view of market expectations for economic growth, inflation, and risk. An upward sloping yield curve is not only normal, but also healthy.
Yet, the increase in yields since the beginning of the Iran campaign (the 10-year yield rising from under 4% to over 4.5% in less than 6 months) and the concurrent increase in energy prices (crude oil moving from $65/barrel to over $80), now challenge the placid opinion that a normal yield curve is just that, normal. At elevated and further increasing long yields, the economy would face a headwind that may prove material. Not only are mortgage rates dependent on long term bond yields, but given the size of public debt outstanding, the continued financing of government balance sheets starts to make investors wary.
Since Secretary Bessent’s announcement of modestly sized purchases of long dated Treasurys, the 10 Year bond yield, after a brief rally, is once again testing the 4.7%-4.75% yield area. It seems to us the market is trying to test Treasury’s resolve a bit more, potentially inviting the Federal Reserve to come to Treasury’s aid. While the US Treasury can buy Treasury’s in the open market, it must finance those with an increase in the issuance of short-term bills. The Fed on the other hand, through its power to create bank excess reserves, can simply “print” money to join the effort.
Against this backdrop, investors are also trying to gauge whether the Federal Reserve will resume raising rates to battle an inflation level that seems stuck above its own target of 2%. Raising short term rates, while trying to keep a lid on long term yields would be a repeat of “Operation Twist” which the Federal Reserve performed to great effect in the 2011-2012 timeframe.
There are many theories on why the Treasury Secretary has decided to act now, both in terms of the timing of the initiative as well as the indicative bond yield he appears committed to defending. Could the timing be purely political, to offset the negative impact of foreign policy on oil prices in light of the upcoming midterm elections, to offset the heave corporate debt issuance by the high expected growth tech sector (which causes a natural short of Treasury bonds as fixed income investors lock in the spread between the corporate yield and the Treasury yield), or is it more straightforward: keeping mortgage rates (which are mostly tied to the 30 US Treasury bond) below 7% (currently at 6.8%)?
We will let readers choose the reason. The relevant issue, we believe, is that Treasury has now identified a level for yields they are now committed to defend. With access to its Treasury General Account, Mr. Bessent is communicating that the firepower he can deploy is massive. For now, we believe Mr. Bessent holds the stronger position, but also believe that, just because he may succeed in keeping a lid on yield, does not mean that yields will be trending lower any time soon (unless the economy significantly cools).
A year and a half ago, we established a 4.5% yield target on the 10-year Treasury bond as a good level to add duration to portfolios. In our 2025 Outlook report we said “Now that 2024 has ended with the US 10-year bond at almost 4.6% we believe that extending maturities beyond 5 years makes sense once again. As long this yield is above 4.5%, we will be looking for opportunities to put capital to work, likely in the 6-8- year maturity window.” Now, with the Treasury’s line in the sand in the 4.7-4.75% range, we believe this is still a good entry point. Nonetheless, since we believe the “market” will continue to test Treasury’s, and possibly the Federal Reserve’s resolve, we don’t believe there is urgency to extend duration. We believe prudent and patient investing may provide the best risk-adjusted returns going forward.
Please feel free to reach out to us with any questions or comments.
Dimitri Triantafyllides, CFA
Chief Investment Officer
dtriatafyllides@forestcapital.net
704-533-9876 (office)