Why are U.S. Treasury yields soaring?

Executive summary:

  • The 10 year U.S. Treasury yield recently hit a 16 year high
  • The Bank of Canada is likely to keep rates on hold at its next meeting
  • U.S. third quarter earnings are projected to be largely flat on a year-over-year basis

On the latest edition of Market Week in Review, Investment Strategy Analyst BeiChen Lin and Product Operations Analyst McKenna Painter discussed the ongoing surge in 10 year U.S. Treasury yields. They also chatted about the latest inflation numbers from the UK and Canada and shared the outlook for U.S. third quarter earnings season.

10 year Treasury yield rises amid signs of continued U.S. economic resilience

Painter and Lin kicked off the segment with a look at the uptick in 10 year U.S. government bond yields, with Lin noting that the yield on the benchmark note topped out near 5% on 19 October its highest level since 2007.

He explained that a large part of the recent climb is due to the notion among investors that the U.S. Federal Reserve (Fed) may need to hold interest rates at high levels for longer periods of time. Markets are increasingly pricing in this risk because of continuing signs of resilience in U.S. economic data, Lin said. Case in point: U.S. retail sales numbers from September came in hotter than expected, while weekly unemployment claims for the week ending 14 October fell to their lowest level since January, he remarked.

Both of these reports suggest that the U.S. labour market remains somewhat strong, which is helping propel the recent rise in Treasury yields, Lin stated. From his perspective, however, investor attention might be better directed toward a potential fall in government bond yields. "I think the market is focusing too much on how high rates could go, when instead it should be focusing on a game of limbo in other words, on how low could rates go," he quipped. Lin explained that even though the market has bought into the higher for longer narrative, the baseline view among Russell Investments strategists is that a mild to moderate recession is still the most likely outcome in 2024.

While there is some uncertainty around a potential U.S. recession, he noted that if one does materialise next year, the Fed would likely have to cut rates by far more than what the market is pricing. Because of this, Lin views any additional upside to Treasury yields as fairly limited, while seeing much more room for yields to decline. "When yields fall, that's a good thing for Treasuries, as prices rise. So, even though some market participants are worried about this higher for longer narrative, I think Treasuries can be an important and attractive defensive lever in investor portfolios," he stated.

Inflation rates ease in the UK and Canada

The conversation shifted to inflation, with Lin noting that in the UK, the pace of consumer price increases continued to soften in September. "UK core inflation last month came in around 6% on a year-over-year basis, which is much lower than the 11% rate the country saw last October," he remarked. However, he stressed that the current rate of inflation is still well above the Bank of England (BoE)'s target rate of 2%, meaning that the fight to tame inflation is far from over.

Compared to the UK, the inflation situation in Canada is a little better, Lin said, as core inflation rates aren't nearly as elevated. In addition, he said that after unexpectedly rising to 4% in August, Canada's inflation rate eased to 3.8% in September.

Just like in the UK, inflation in Canada still remains notably above the Bank of Canada (BoC)'s 2% target, Lin said. However, there are some recent signs that the Canadian economy might be under pressure, he said. "Amid this backdrop, I think the BoC will probably keep rates on hold at its 25 October meeting. However, central bank officials are likely to still retain some optionality, and will therefore probably emphasise their commitment to bringing inflation back down to target," Lin stated.

U.S. Q3 earnings expected to be largely flat year-over-year

Painter and Lin wrapped up the segment by discussing the key takeaways and watchpoints from U.S. third quarter earnings season, which is still in the early stages. Lin said that some of the big banks have reported, with a mix of positive and disappointing results. A few companies from other sectors have also reported, he said, including Tesla, which expressed concern over the affordability of its cars due to high interest rates.

Looking at a broader macroeconomic set of data, Lin said that third quarter earnings for S&P 500 companies are expected to be relatively flat on a year-over-year basis. "This wouldn't be the worst possible outcome, but it clearly wouldn't be the best either," he remarked.

Lin expects more signs of difficulty in the U.S. small cap space, noting that many companies in the Russell 2000 Index are exposed to variable interest rate financing structures. On average, he anticipates that some of these companies will report year-over-year earnings declines in the double digits for the third quarter.

Glancing ahead to 2024, Lin noted that many analysts expect earnings per share (EPS) growth to range between approximately 8%-15% for most of the year. "The problem with this outlook is that if a U.S. recession were to materialise, earnings could actually contract by 10%-15%, instead of expanding by that amount," he stated. This, in turn, could lead to further downside risks to equities, Lin added.

That said, Lin stressed that now is not the time to panic. "Regardless of whether we're in strong or weak economic times, the most important thing an investor can do is stay disciplined, have a plan and stick to it. Doing this allows you to weather any sort of economic outcome," he concluded.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.