The Impact of Higher Treasury Yields on Bond Investors

As the year unfolds, the consequences of higher long-term Treasury yields have become painfully clear for investors in beaten-up bonds. When yields rise, bond prices tend to fall, particularly for older bonds that were issued when yields were lower. Who wouldn't want the same debt with the same risk, but suddenly at a higher return?

However, if you hold the belief that a U.S. recession is imminent and that inflation will continue to decrease, you should also expect the 10-year Treasury yield to decline from its current cycle peak to the forthcoming trough. According to Macquarie strategists, this finding was outlined in a recent client note.

Their chart demonstrates that on Thursday, the 10-year Treasury yield stood near 4.7%, while the Federal Reserve's short-term policy rate hovered between 5.25% and 5.5%. These convergence levels are nearing their highest points since the notable summer of 2007.

"When the Fed-funds rate and the 10-year Treasury yield align, it often signals the onset of a recession," highlighted Matt Lloyd, Chief Investment Strategist at Advisors Asset Management during a recent discussion.

Between 2004 and 2006, the Fed gradually raised interest rates to stabilize the economy and control an overheating housing market. By March 2007, Fed Chair Ben Bernanke expressed his belief to Congress that the subprime mortgage crisis would likely be contained. However, complications arising from adjustable-rate mortgages and the subsequent subprime debt crisis led to a succession of rate cuts. These cuts lowered the Fed's policy rate to nearly zero, where it remained for nearly a decade.

Recalling the Past: Lessons from the Economic Crisis

The sales and trading strategy team at Macquarie, led by Thierry Wizman, reminds us of a critical moment in history. Back in the late summer of 2007, when concerns about the "sub-prime" and "alt-A" mortgage markets were emerging, the 10-year yield was on the verge of matching the Fed's policy rate. Surprisingly, the economy appeared resilient at that time.

This time around, as the Fed raises rates to combat pandemic-induced inflation, a different scenario unfolds. Unlike the past, where waves of mortgages were repriced at unsustainable levels, most homeowners today have secured historically low 30-year fixed rate mortgages. This has not only shielded many families from the shocks of higher interest rates but has also posed challenges to the Fed's battle against inflation.

However, should a slowdown be in the cards, the Macquarie team suggests turning to bonds as a wise investment.

As we await Friday's jobs report for September - an essential indicator for the Fed's efforts to reduce inflation to its 2% annual target - stocks (SPX DJIA) experienced a decline on Thursday.