Why 5% Treasury Yields May Be Just the Beginning

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1:51Bloomberg Audio Studios. Podcasts, radio, news. The whole edifice of finance is built consciously or otherwise on this keystone of the 10-year yield. Everything else adds on to that. And a lot of structures haven't been tested with a 10-year yield as high as 6%. So this is potentially a big sea change that is still only starting.

2:23Stephanie Flanders:I'm Stephanie Flanders, Head of Government and Economics at Bloomberg, and this is Trumponomics, the podcast that looks at everything in the economic world of Donald Trump. This week, the US government bond market crossed a line that investors have been watching for years. On Monday, the US 10-year Treasury yield, in effect the rate the federal government borrows at, breached 5 % for the first time in several years. And on Tuesday, it went higher to 5.04%, the highest since 2007. And that's up from just 1.3 % five years ago. In living memory, there's never been such a dramatic rise in the interest rate that investors demand to lend to the US government.

3:10Stephanie Flanders:Now, in case you're wondering why this matters to you, that yield historically sets the tone for pretty much all private lending rates in the US and has a massive influence on the cost of money for all of the world's borrowers, governments, businesses and households. In fact, arguably, it's the single most important price in the world. So there. Well, we're recording Wednesday morning ahead of the Federal Reserve's latest interest rate decision and markets are watching closely for what Kevin Walsh and the Monetary Policy Committee decide about the short-term rate that the Fed controls, the federal funds rate.

3:47Stephanie Flanders:The overwhelming consensus is that the US central bank will raise that short-term rate today, but it actually doesn't matter for our conversation what happened, because whatever the committee has decided by the time you listen to this, there probably isn't very much the Fed can do about those higher bond yields, because many of the big structural forces that drive the longer-term cost of money are now pointing to higher yields for some time to come. In fact, far from being a ceiling, 5 % may be the new floor for the most important number in global finance. So I want to get into that and also how much higher the cost of borrowing could go from here with John Authors joining me again from New York, Bloomberg opinion columnist, author of the Points of Return newsletter.

4:35Stephanie Flanders:Welcome back, John. Thanks for being here. I know that you're sort of waiting whippet-like for the Federal Reserve decision as we speak. This is a great way to occupy. These are some of the deadest hours there ever are. I could spend time looking at what markets are doing in the hours before we hear from the Fed. There's really no point. A lot of traders actually sleep in because, or by their standards, sleep in because they know the action is going to start at two. We've discovered that you're doing absolutely nothing on a Wednesday morning. I was too busy twiddling my thumbs otherwise. So, yes, yes.

5:05Stephanie Flanders:And here in London is again Jamie Rush, Bloomberg's Director of Global Economics, and in fact, my co-author with the Chief Economist Tom Orlick of a book on this subject, The Price of Money. Jamie, thanks for being here. Great to be back.

5:21Stephanie Flanders:John, we will get into the long-term forces driving this in a minute with you and with Jamie. But if we're just thinking about the run-up we've seen and the sort of discussion around it this year, this big increase in yields, I guess, in effect, investors becoming less keen on holding government debt. Why? Because the world is getting a somewhat more expensive place, because de-lobalisation is happening, and that makes everything more expensive than it used to be. Because the quantum of debt that governments hold is enormous, that doesn't necessarily mean that they're more likely to default, but it does mean if you've got that much more debt that you need to offer that you may, through the laws of supply and demand, you're going to have to offer a higher rate to get people to lend to you.

6:10Further, other than the Iran war, which is obviously an external shock, but I think the somewhat more endogenous shock that people still hadn't really seen coming is the amount of borrowing being done to fund AI data centres. That's the biggest real new investment in new capital in some decades. I've seen estimates that it's actually going to be a bigger proportion of the US GDP than the Marshall Plan was of Western Europe's GDP in the years after. To give you an idea of that, it's comparable to what FDR did in the New Deal. That is being done by private sector actors who are mostly possessed of extremely strong credits.

6:53Amazon and Google are not quite as strong credits as Uncle Sam, but broadly speaking, you do expect them to pay back. So you've got this big new source of supply, which again, laws of supply and demand. If there is more debt looking for people to lend to them, you're going to have to offer more before they will lend to you rather than to somebody else. But in terms of what we couldn't absolutely see coming 12 months ago that has happened, those are the main things.

7:22Stephanie Flanders:We are talking on the day of the Fed decision. Without getting into the impact of this particular decision, there is an expectation, whether it's two or three, or maybe Kevin Walsh is hoping one, but there's a pretty strong expectation we're going to be in a tightening cycle over the next few months, possibly a year, depending on how things go. Normally, and you've been looking at the way markets react to these things for many years, what does that mean for yields? There are important differences between overnight rates and 10-year yields, which I don't think we want to get fully into the thickets of why that is.

7:56But yes, there will be a connection when the Fed is in a tightening cycle. Generally, that does mean that 10-year yields will also rise. I cited some research by Jim Reed of Deutsche Bank, who's a very good financial historian. In round numbers, you'd expect a tightening cycle to last for 75 basis points or a percentage point. That's what the market expects. Broadly speaking, the base case at this moment is that we will have a 10-year yield more like 6 % than 5 % 12 months from now. And that is historically, I don't think the rate, the 10-year yield was ever as low as that during the entire Reagan presidency.

8:38And that was still an era of great, prosperity by the end of it. Yes. So it's certainly not the end of the world. If you're only a bit younger than me, you have difficulty remembering a world, as an adult, as a professional, you have difficulty remembering a world with yields as high as 6%. There is definitely reason for concern that finance has built, as you said at the beginning, the whole edifice of finance is built consciously or otherwise, but on this keystone of the 10-year yield. Everything else adds onto that. And a lot of structures haven't been tested with a 10-year yield as high as 6%.

9:20And a lot of people active in this don't personally have the experience of what that's like. And human fallibilities, as we all know, very important here as well. So this is potentially a big sea change that is still only starting.

9:36Stephanie Flanders:And we can all sort of have a discussion around sort of some of the risks embedded in what you've just said. Turning to Jamie, I think it's worth sort of taking a step back and thinking about some of those long-term drivers for yields, which sort of creep up over time, but it sort of feels like have really asserted themselves in the last few years. and that was what actually this research on the underpinning that book the price of money from the standpoint of those long-term forces what we're seeing is not very surprising and indeed five percent could now be a new floor is that right yeah i mean turning to just very briefly on how much should bond yields move when the fed moves it's like john says you should expect some move up in 10-year yields.

10:23But is the fundamental situation in Iran and more expensive oil going to be with us forever, keeping inflation high forever, and therefore interest rates high forever? I think the answer has to be no. I think everyone would agree with that. So if that's true, why should it be the case that 10-year yields, 15, 20, 30-year yields have all moved up? And it leaves you in search of a better explanation. And some of those explanations lie in the structural factors that determine interest rates just like you just flagged. When we think about interest rates globally, I mean, we live in globally integrated capital markets.

10:56So you have to think about the whole world. You have to think about investment, the desire to invest, the desire to save. What are the things which are tipping the balance between those two objectives? And yeah, we heard it. So John mentioned it, demographics, crucially important, baby boomers saving for retirement. Well, that bulge in the population is now moving through the labor market. Things are going to be turning around. Productivity growth, I mean, it's slowed for a long time. Now it's picking up. It may pick up a lot if AI turns out to be as good as everyone hopes. And that's going to suck up exactly the sorts of capital flows that we've just been discussing.

11:36So those investments, they're going to be sustained if this technology works, and it's going to be creating demand for capital. And in particular with AI, because the returns and the productivity gains could be so big, they're going to be very price insensitive. They don't mind what the interest rate is. So it can take a lot to suppress it. So all those factors are pushing up. And then on top of that, of course, you have got government debt just hitting new highs year after year. And government's quite readily doing nothing to address it.

12:18Stephanie Flanders:John, is there a positive spin on this, which is you have effectively had that earlier in your discussion that, you know, interest rates are going up because there's just there's more exciting things for places to people to put their money. Whereas when we had interest rates at the rock bottom and governments were effectively being paid to borrow from the markets is because investors had nowhere better to put it. Yeah, I mean, there's an old stand up comedian joke that people driving secondhand Reliant Robins, which are three-wheeled cars, wants to get a speeding ticket so they can prove it can drive that fast.

12:49There are many unwelcome facets to higher yields, but they do very strongly suggest that something is going right, that if the price of money needs to go up to ration all the different uses people now have for it, if the nominal GDP is is rising healthily, that is plainly, you know, in 1066 and all that terms, a good thing. It's not particularly about alarm that the US may not be good to repay its debt. It's not about the decay of financial institutions, horror at Trumponomics, that's in the thing rather than the podcast, etc. No, that isn't to say that such a thing couldn't happen. And it isn't to say that there couldn't be a tipping point ahead of us when that rationing point, that equilibrium point for the 10-year yield proves to be at a level that really hurts the government, that really creates issues in the economy.

13:50But as it stands at the moment, yes, there are ways in which this is healthy. And also another very important point, part of the reason yields were as low as they were for as long as they were, was that they were being interfered with to be held low. Explicitly so in the case of Japan and only somewhat less explicitly in Europe and the US. That was an unnatural state of affairs. So some of what we're seeing is the removal of an unnatural state of affairs and a return to a situation where capitalism has more of a chance to work with the disciplining mechanisms necessary for it to be efficient for all.

14:32So that's my summation of why, yes, there are ways this is a good thing.

14:36Stephanie Flanders:It is interesting you mentioned the question of control. So if the conclusion of our very educational discussion so far is that it's actually not a bad thing to have high yields in many ways, it shows good things about what's going on in the world, and it's also driven by structural forces that governments can't really control in the short term. Donald Trump doesn't seem to think it's desirable and he does seem to think it's something that he should be able to control and perhaps more surprisingly his treasury secretary who is an old master in the markets also seems to think that he can have an influence over bond yields has been various bits of financial engineering he's attempted over the summer to bring down on certain yields.

15:21I mean, I'll ask both of you, but Jamie, can they control any of this? Well, maybe for a time, but at what cost? I mean, if you're trying to fight fundamentals which determine globally, then it's very difficult and you are going to have to pay some sort of, it's a bit of a zero-sum game trying to fight these things. If the fundamentals are pointing towards an equilibrium price of money around the world, which is higher than you like, your only option is financial repression of some sort. And of course, we've seen that backfire many, many times. And generally, this could be a very good thing, like John says.

15:59But who is it going to be good for? And that depends on who gets the rents from the AI, whether you can tax them. Otherwise, if you can't, it's very, very bad for governments. It's going to be extremely costly in terms of the interest bill and not generate any revenue. So there are some big uncertainties there and big open questions.

16:18Stephanie Flanders:Yeah, we had a good discussion a few months ago about the possible existential risk that AI poses to the income tax base. I mean, John, I haven't had a chance to talk to you over the summer as Scott Besant has been doing his histrionics and making his great statements about I'm the house now. And the bond market has a fever. Yes, it's really startling language for a Treasury Secretary. Well, also for someone who, you know, actually knows about the difficulty of fighting the market. So I just wonder, is your considered conclusion from that, that he doesn't really believe what he's saying or that he's had some kind of fever himself?

16:54Stephanie Flanders:Or how do you read it? I'm sure he believes that he wants yields to be lower if they possibly can. And he said that. And there are plenty of sensible reasons why it would help him if he were. and he also wants a weak dollar, which if you're throwing in your lot with protectionism, you could do with a weak dollar. If that's the strategy, which it more or less has to be given that that's the platform on which the president has been elected, then it's part of a package of things that makes sense for Besant to try to achieve. The comment about the House he made regarding the yen, where it was a very startling decision to intervene to help the Japanese strengthen the yen.

17:37And that's ultimately because otherwise, he seemed to be concerned that otherwise, the Japanese would just have to strengthen the yen. If you're the Japanese authorities involve selling treasuries involved doing something which pushes up treasury yields. And he was concerned enough about the risk of any new source of treasury sales that he wanted to do that. I think his bluff has definitely been called. The main thing he did was he increase this very small program in the greater scheme of things where the treasury can buy back debt he announced that he was going to at least double it uh he in fact tripled it but the market was expecting it to be even more than that and so yields went up and then when they first buy back under the new regime happened they didn't actually buy back all that they could have done because the people working for the treasury were actually looking for good deals if you're intervening you just take the hit it costs you some money to intervene that's returning to the very short term is why we had the very sudden rush up to five percent in the last few days before we recorded was because uh um scott besant's i think i gather you think as well rather ill-advised language backfired that his bluff was called and indeed his old boss was among the people who recommended in an op-ed that traders should call Mr.

18:59Besson's bluff. He's in a very difficult situation. Jamie raised the issue of financial repression, which is almost certainly not a good idea, but can in certain circumstances be the least worst option. I think there probably is a good case that financial repression just directly intervening to limit yields on bonds, which is another way of forcing people to lend to the government at artificially, at uneconomically low rates. That was probably the best way to deal with war debt in the years after the Second World War. It's difficult to see how we square the circle that Scott Besson is currently trying to square without some modern version of financial repression and of some way in which the Treasury steadily becomes more important and the Fed becomes less important.

19:45Just to make clear, what the Fed can do that the Treasury cannot is actually create the money. QE involves creating money to buy back bonds. Well, currently can't create the money. Yes, exactly.

20:00Stephanie Flanders:There's plenty of rules that are being torn up by this administration. Precisely. And that's the fascinating shift that we could see. Well, I hesitate to give the president more ideas, but I guess the sort of one final beat on this particular conversation is, Jamie, in this world where you've already introduced quite a lot of friction and sort of geopolitical pressure in the world of trade, you're sort of mixing up your different diplomatic instruments. You're imposing tariffs on people for geopolitical reasons and vice versa. Any effective financial repression would probably have to at some level be global or at least have an international element.

20:37Stephanie Flanders:Is there a world in which the administration or Trump starts using diplomatic pressure to force countries, for example, to continue to invest their foreign exchange reserves in treasuries? I mean, he certainly talks about that in the context of the BRICS. He doesn't like the idea that people are going to move away from the dollar. I saw the Dutch central bank had said it was buying more gold the other day because it was getting rid of some of their dollars because of geopolitical risk. Presumably, Donald Trump could threaten them not to do that and use quite effective tools for preventing them.

21:13Well, he has bashed people over the head with tariffs once or twice in the past to achieve aims, I suppose. I think it's a very reasonable threat. I mean, he could use leverage. Where would he go for that? Rather than sort of geopolitical strategic rivals, it would be people with loads of money. So you would go to Japan, you'd go to the state pension fund, and you'd say, right, you need to buy treasuries. And you could do that with other players as well. I suppose you'd have limited impact on China, but you could try and persuade them to direct more of their resources towards treasuries, which, of course, would take us back to where we were during the go-go years of globalization.

21:51But, I mean, again, this stuff comes at a cost, though, because you might get investment in treasuries, but they would sell other dollar assets potentially to finance that. So you end up with just a bit of a merry-go-round and reshuffling of assets with no actual net effects on US borrowing costs. So he could go down that route. I would not be surprised if he did. I think it would be unlikely to solve his problems.

22:12Stephanie Flanders:Jamie, on the sort of longer term, you know, if we're in a 5 % or 6 % world, even if you think that's healthy, ultimately, and indeed not very different from what it was years ago, we've had quite a long period where it was very low and we tend to worry about those transition moments in the financial system. From an economist standpoint globally where would you look for those is it mainly governments who are going to face that kind of transitional cost? I'd be yeah mostly focused on the sovereigns I think because if you think about how they finance themselves going from three to six is a big change compared with going from say six to nine I mean in terms of in terms of the burden that creates in debt servicing costs relative to your balance sheet, much worse to go from a low rate to a high rate than a high rate to a high rate.

22:58And so for sovereigns, that ticks that box. So I would be looking there. It also has implications for lots of companies who perhaps borrowed at low rates or refinanced at very low rates during the post-pandemic era. But they seem to be managing their finances reasonably well and refinancing where they can.

23:16Stephanie Flanders:John, I mean, I guess the last word with you. I mean, you actually had a column saying, who's afraid of big bad bond yields? And your basic view was the stock market has not been troubled by this because the rise in yields, for all the reasons we've discussed, comes from broadly sort of good reasons, not scary reasons. We have worried a bit about the things that Jamie has said, you know, that hidden beneath the surface, there's all these companies that might go bust when they have to refinance their debt. Haven't seen that much of that. I mean, where would you be looking for painful transitions as we go to this sort of 5 % or 6 % world?

23:50the US housing market has to be the number one. And that's that is what Donald Trump, obviously, being a property developer understands very clearly. And that market has broadly come to a standstill and will continue to be at a standstill if long term rates continue to rise. That's one of the one of the most direct transmissions from high long term yields is obviously into the rates you can at which you can finance mortgages as the very low mortgages that people took on during the pandemic low rate mortgages will begin to be expiring soon. That could create some interesting developments, whether they're still going to be able to finance it at their new rates.