Will the 10-year Treasury yield keep rising if the Fed starts hiking?: McGeever

ORLANDO, Florida - US interest rate-hike cycles are almost always accompanied by a rising 10-year Treasury yield. With the benchmark yield breaking above the psychologically important 5% threshold, investors are asking how high it could go.

The likelihood of the Federal Reserve raising interest rates on Wednesday – which would be the first hike in over three years – is around 90%, according to interest rate futures markets. Futures pricing also indicates three further 25-basis-point increases over the next year, resulting in a terminal rate — the expected peak of the policy tightening cycle — of around 4.60%. That's essentially 100 basis points above the midpoint of the Fed's current 3.50% to 3.75% target range.

If this scenario plays out, it will be the shallowest tightening cycle in decades. There has been a smattering of "one and done" hikes in the past, but generally, when the Fed raises rates, it starts a longer cycle. Logically, this almost always lifts the yield on the 10-year Treasury note, the global benchmark borrowing cost against which trillions of dollars of mortgages, corporate debt and other loans are referenced.

The weight of history suggests the 10-year yield is likely to head north. Yet since the pandemic, investors have been grappling with a new confluence of economic, market and policy dynamics that has rendered many rules of thumb irrelevant. The past may be even less of a guide to the future than once assumed.

While the Fed’s policy decision on Wednesday may seem clear-cut, what happens after that is anything but.

10-YEAR YIELD HEADING FOR 6%?

That said, it's still useful to review past tightening cycles for clues about what might lie ahead.

Analysts at Deutsche Bank have looked back at what they deem to be the last 12 proper hiking cycles since the early 1960s. They find that the 10-year yield rose, on average, around 114 basis points in the year after the start of a cycle. In only one, Alan Greenspan's "measured pace" cycle of 2004-06, did the 10-year yield fall during the first year.

Warren Pies, founder of 3Fourteen Research, has analyzed the previous seven hiking cycles going back to 1986-87, and his findings are remarkably similar. According to his numbers, the 10-year Treasury yield has risen around 115 basis points over each cycle, on average.

Curiously, the number or magnitude of rate hikes isn't a particularly strong guide to how the bond market will react. According to Pies, the 10-year yield rose most during the shallowest rate-hiking campaign, soaring 217 basis points across five hikes in 1986-87 (Deutsche Bank argues there were only four increases in that mini-cycle).

Conversely, the longest hiking cycle of the past 40 years, spanning 17 consecutive increases over 2004-06, saw the 10-year yield rise only 62 basis points, the second-smallest increase of the seven cycles Pies analyzed.

Of course, no two cycles are the same, and the circumstances leading up to this one, presuming it unfolds, are unique. The 10-year yield has already risen around 100 basis points in the last year, significantly more than the average increase before a Fed tightening campaign. At 5.00%, it is now at a level many investors are likely to find tempting.

Bonds are looking extremely attractive when adjusting for inflation, too. The yields on 10-year and 30-year Treasury Inflation-Protected Securities (TIPS) are 2.60% and 3.10%, respectively, both the highest since 2008. Strong demand at these levels means yields may not rise as much as they have in past cycles.

On the other hand, Treasuries can still get cheaper. The forces that have driven yields to these highs — worries over debt and deficits, AI borrowing and investment, energy-driven inflation and policy credibility — haven't disappeared. If history is any guide, Fed tightening could push the 10-year yield up more than 100 basis points.

Is the US economy — and the world — ready for a 10-year Treasury yield of 6% or more? We may be about to find out.

(The opinions expressed here are those of the author, a columnist for Reuters)

(By Jamie McGeever, Editing by Marguerita Choy)