Is the Treasury Bond Massacre Finally Over?

The nation’s inflation problem is far from solved, and the Federal Reserve remains committed to keeping short-term interest rates elevated. But longer-term government bonds may finally be worth a second look after some 14 months of carnage.

Although the Fed has short rates pinned in the vicinity of 4% to 5%, longer-term yields tend to start falling much sooner as monetary tightening cycles come to an end, especially as markets look ahead to the risk of a looming recession. In fact, during the past five rate-increase cycles, 10-year notes have on average peaked and begun to rally 206 days before the first Fed cut. Here’s the basis-point change in the 10-year Treasury in the 12 months before each rate reduction:

In other words, longer-term yields can probably decline from current levels even as the Fed keeps its target rate elevated, provided inflation continues to moderate. The latest consumer price index report showed that core inflation is running at around 5.8% based on the three-month annualized rate. Although noisy, the latest data may provide some support for that argument, and traders on Thursday were in full-on glass-half-full mode, pushing yields down 24 basis points, the biggest one-day drop since March 2020. Here are a few possible paths to consider for longer-term Treasuries.

Bull Case

One simplistic way to think about the fair-value yield on a 10-year Treasury is as the average of the expected yields on 10 one-year bills bought over the next decade. Assume, for instance, that you think yields on 12-month securities will average 5% in 2023, 4% in 2024 and 3% in 2025 — only a slight simplification of the prevailing thinking in markets. After that, you think rates will converge on the long-run “neutral” level of 2.5% on the federal funds rate, according to the median estimate of the members of the Fed’s rate-setting committee. That scenario yields an implied fair-value yield of around 3% on 10-year notes, 84 basis points below the current 3.84%.