US Yield Curve - Risk of Further Steepening
KS Advisory - Insights - March 07, 2024
“It (term premium) could move higher from levels seen in last 10 years given increase in aggregate debt outstanding, potential increase in inflation risk premium and if Q.E. programs are less ambitious during future downturns.”
(Treasury Borrowing Advisory Committee, August 2023)
One of the most important economic and market variables globally is the shape of the yield curve. While many economists and market experts anticipate the long end of the curve to move lower, we believe this outcome is highly unlikely.
Growth, inflation, and central bank policy are important factors influencing the yield curve, but they are not the only ones. To accurately predict long-term U.S. rates, a broader set of variables must be considered. Although the possibility of lower long-term U.S. rates exists, it is significantly less likely than the current consensus in financial markets suggests.
Given both global and domestic challenges, U.S. government bonds are likely to demand a higher term premium. Consequently, the risk is skewed toward higher, not lower, long-term rates.
Starting with the ever-popular market topic of inflation: In our August 2022 publication, Secular Inflation is the New Normal – Get Ready, we argued that while cyclical inflation may ebb and flow, secular inflationary pressures will persist, establishing higher inflation as the new norm.
Our analysis identified several key factors driving this secular inflationary trend, including:
- Declining global population growth rates
- Declining global workforce participation
- Reduced global labor mobility
- Growing global labor skills mismatch
- Declining global trade openness
- Decreasing global supply chain integration
- Decreasing global financial openness
- The influence of UNSDG (United Nations Sustainable Development Goals)
- Increased climate event risks
- Rising global per capita income
- Changing/decreasing central bank inflation-targeting regimes
These variables, among others, suggest that inflation is not just a temporary phenomenon but a structural shift in the global economy..
Considering these factors, we must also account for the ongoing and unprecedented wealth transfer of approximately $84 trillion (1) over the next twenty years. Will this not impact spending, inflation, and overall economic activity? Undoubtedly, it will—likely in ways we have yet to fully grasp. Younger generations, at least for now, appear to lack the same affinity for traditional assets like stocks and bonds as their predecessors.
This generational shift in preferences and financial behavior could amplify inflationary pressures, leaving inflation risks skewed to the upside for the foreseeable future. Unlike in previous decades, younger generations now have access to alternative capital and funding sources, including online platforms that significantly enhance access to financing.
Developments in the energy sector also deserve attention. The U.S. is now a net energy exporter (see the chart below on U.S. net petroleum trade, net imports) and benefits from access to cheaper oil (refer to the Brent-WTI spread chart). This plentiful and relatively insulated energy supply strengthens the U.S. economy against global disruptions. Energy security remains a cornerstone of economic vitality, and the U.S. has achieved this through a sustained focus on reducing oil dependence, particularly since the 2008 Energy Security Leadership Council report, which outlined a national strategy for energy security.
Moving beyond inflation and growth, it is crucial to consider a broader set of variables when assessing the medium- to long-term direction and shape of yield curves. In the case of the U.S., divisive identity politics, fiscal irresponsibility, and repeated displays of hegemonic behavior—such as “shock and awe” policies and ongoing regime change attempts—have eroded its global standing and respect. This decline coincides with other nations strengthening their foreign, fiscal, and monetary policy frameworks, as well as improving their reaction functions.
Adding to this dynamic is China’s rise and its growing influence on the global economy and power politics. All of these factors unfold against the backdrop of an increasing supply of U.S. Treasury securities (refer to the chart above on gross issuance and the debt projection chart below).
In such a complex environment, the risk to the U.S. sovereign credit rating is profoundly underestimated, further complicating the outlook for the yield curve.
In the most recent U.S. Treasury presentation to the Treasury Borrowing Advisory Committee (TBAC), it was noted: “The term premium could move higher from levels seen in the last 10 years given the increase in aggregate debt outstanding, potential increase in inflation risk premium, and if QE programs are less ambitious during future downturns.”³
While many expect U.S. long-term rates to decline, this remains a plausible assumption but is significantly less probable. A stronger-than-expected economy, persistent secular inflationary pressures, growing debt supply, and declining global demand all point to upward pressure on long rates.
Over the long term, the term premium for U.S. government bonds is poised to rise. As such, the risk for U.S. long-term rates remains skewed to the upside.⁴
References, Notes
1. Merrill Bank of America, Will the ‘Great Wealth Transfer’ transform the markets?
2. U.S. Congressional Budget Office - The Budget and Economic Outlook: 2023 to 2033
3. 4. Treasury Presentation to TBAC, 24 August 2023.
4. At some point in time, in the future, we cannot rule out the possibility of a U.S. Treasury and Fed-orchestrated effort to put a yield curve control program in place to limit long rates from rising beyond a certain level, which they believe is problematic. Like Japan, the U.S. may replicate the Japanese model where yield curve control is orchestrated between the Ministry of Finance, which issues government debt, and the central bank, the Bank of Japan, which buys much of it. The Bank of Japan holds 53.9% of all Japanese government bonds (The Japan News 21 Dec 2023).
Image - Yield Curves Where History Does Not Repeat - B.M. Khan - Ai generated, February 24, 2024.
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