Oct 27, 2023 5 min read

DEEP DIVE: What's Driving Bonds?

DEEP DIVE: What's Driving Bonds?

In his interview Thursday with Bloomberg’s David Westin at the Economic Club of New York, Fed Chair Jerome Powell was asked about the bearish impact of the increasing supply of government debt on the bond market given that the Fed is no longer buying Treasury securities and that foreigners reportedly are reducing their purchases as well. Powell responded that buying by foreigners has “actually been pretty robust” this year.

That statement provides an opportunity for Melissa and me to update our analysis of supply and demand in the Treasury market. Consider the following:

(1/7) Bears versus bulls.

In our August 14 Morning Briefing, titled “Disinversion,” we wrote: “[T]he supply of and the demand for bonds isn’t usually as important to the determination of the bond yield as are actual and expected inflation and the expectations of how the Fed will respond to them.” The 10-year Treasury bond yield was 4.19% at the time, but we were increasingly concerned that it was going higher because of the imbalance between supply and demand.

Favoring the bears in the bond market, we observed, “is the rapidly widening federal deficit and evidence that demand may not match the supply of Treasury securities unless their yields continue to rise. Favoring the bulls, in our opinion, is that since last summer inflation has been on a moderating trend that should persist through 2025 without any further increases in the federal funds rate.”

Inflation remains on a moderating trend. However, the bond yield is now around 5.00%, as supply concerns have mounted along with the federal debt. Supply became a major issue when the Treasury announced significant increases in its auctions on July 31. From July through September, the Treasury needed to borrow $1.01 trillion, $274 billion more than was announced in May. The day after that announcement, on August 1, Fitch Ratings downgraded the government’s credit rating from AAA to AA+. That underscored the significance of the government’s profligate borrowing and accentuated investors’ supply concerns.

(2/7) Is 5% high enough?

The question now is whether the 10-year Treasury bond yield, at 4.93% on Friday, is high enough to attract sufficient bond buyers to equilibrate the market’s supply and demand. We think so. The 10-year yield is back to the highest reading since June 2007 (Fig. 1 below). We’ve previously characterized the bond yield range of 4.50%-5.00% as a return to the old normal range before the Great Financial Crisis from 2003 through 2007. The big difference between now and then is the size of the federal deficits, which is partly attributable to the rapid rise in the net interest outlays of the federal government.

(3/7) Bond Vigilantes more powerful than ever.

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