Liz Looks at: Rates, Spreads, and Yields

By: Liz Young Thomas · October 05, 2023 · Reading Time: 5 minutes

Wicked Witch of the Spread

Oh my. Long-term Treasurys have had a rough autumn so far — the 10-year yield has risen roughly 70 basis points since the end of August and an ETF representing 20+ year Treasury bonds is down more than 11% over that period.

Aren’t bonds supposed to be a lot more boring than this? Yes, in a normal environment. Or at least in an environment where we’re not contending with unwinding 15 years of abnormally loose monetary policy. But that’s not the situation we’re in right now, hence the bond distress.

It’s not just about yields themselves, but also about their relationship to each other, also known as the inversion of the yield curve. This inversion, which we’ve all been obsessing over since summer 2022, narrowed materially in recent months — moving from -110 bps in early July to just -33 bps as of writing.

Many fall prey to the fallacy that the inversion is the problem, and if we can get out of it, things will improve. On some level that’s true, we do want the yield curve to return to a more normal, upward sloping shape. But the path it takes to get there is typically the painful part for stocks, and usually the result of weakening economic conditions.

The nature of this re-steepening, however, hasn’t reflected the aforementioned scenario. The spread between 2- and 10-year Treasurys has narrowed primarily due to the 10-year yield rising, which theoretically suggests that the economy is in good shape, and is withstanding rate hikes just fine.

If the 10-year yield can keep rising and bring the curve back to a healthy shape (such as a 2s/10s spread closer to its long-term average of 88 bps) without inflicting pain on businesses, consumers, or markets along the way, we’ll get our soft landing wish. Bear in mind, if the 2-year yield stays where it is, reflecting the Fed’s higher for longer mantra, this would require a 10-year yield of nearly 6.0%.

Engineering a soft landing with those conditions would need all other things to stay constant or improve along the way. We don’t have the real estate (pun intended) to cover every possible land mine in this piece, but one of the most important puzzle pieces is how this has affected consumers, and how it will continue to squeeze their spending, if rates stay this high.

Consumer in a Twister

A fundamental concept of consumption is that when times are good and people are feeling optimistic, they spend more money. In order to have that money to spend, they need to be participating in a healthy labor market, and have borrowing available to finance their purchases. Although debt can be seen as negative, it’s a big part of what allows spending to continue in a growing economic environment.

Debt is fine as long as consumers and businesses can afford to take it on, and maybe even enhance their wealth or returns as a result. But when taking on debt becomes an outsized burden, or downright prohibitive, consumption is likely to take a hit.

As we can see in this chart, 30-year mortgage rates recently hit their highest level since August of 2000, nearly 7.9%. The average mortgage payment on a median-priced home in the U.S. is currently $2,394, which is the highest it’s ever been. That’s partly due to the sharp rise in mortgage rates, and partly due to stubbornly high home prices. Mortgage rates tend to follow 10-year Treasury yields, which have seen a meteoric rise this year. Needless to say, financing a home right now is not cute.

But it’s not just about the housing market, consumers need other types of borrowing in order to spend money, most of which tracks the Prime Rate (also shown in the chart above), which in turn tracks the Fed Funds rate. With 525 bps of Fed rate hikes under our belt, the prime rate is also the highest it’s been since 2000.

Which means consumer borrowing costs are the highest they’ve been in 23 years. That’s bound to put a dent in spending eventually.

The Wizard of Washington

We’ve established that consumer borrowing costs are high because of where yields and policy rates are. The last piece to cover is that Treasury yields aren’t just a reference rate for borrowing costs, they’re a real cost to the U.S. government for new borrowing. And since running at a federal budget deficit seems to be our norm, the government has to keep borrowing. Except right now, it’s borrowing in a really expensive environment to do so, which further exacerbates the budget shortfall, which then requires more borrowing. Not a good feedback loop to be in.

At this rate, the government’s interest expense as a percent of GDP is projected to rise considerably in the next few decades. It’s very possible we don’t continue at this rate for a variety of reasons, but it’s clear from the Congressional Budget Office’s expectations that this is a risky inflection point.

Dramatic projections aside, the current rate and yield environment is difficult for consumers, businesses, and the government to endure. They’ve all endured it so far, much to many investors’ and economists’ surprise, but it’s still possible that the projections have only been wrong about the timeframe, not the eventual outcome.


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