[Holiday Special Edition] The Pitfalls of the 5% US Interest Rate Era. Why Do Long-Term Rates Fall Even When Inflation Re-accelerates? What Is the True Nature of the Term Premium?

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“If inflation accelerates, interest rates will rise.”

This is an explanation often heard in financial markets. However, in the US Treasury market this week, we saw price movements contrary to that conventional wisdom.

Looking back at last week’s market trends, the US September CPI released on October 14th showed a headline increase of 3.7% year-on-year and a core increase of 2.6%, exceeding market expectations, and the PPI on the following 15th also significantly exceeded the expected 0.6% with a 1.3% month-on-month increase.

However, the US 10-year Treasury yield on the 15th closed at 5.06%, down 13bp from the previous day. Despite successive upward surprises in inflation indicators, buying became dominant in the bond market.

To understand this movement, I believe it is insufficient to view long-term interest rates merely as an “inflation thermometer.”

In fact, long-term interest rates incorporate not only future policy rate outlooks but also expectations for the economy, risk premiums demanded by investors, and hedging transactions by financial institutions, among various other factors.

In this holiday special edition, I will explain the three factors that move the US 10-year Treasury yield and the impact on future stock and currency markets.

🌶️ ① The US 10-year rate is not determined solely by the “current policy rate”

First, it is important to understand that the US 10-year Treasury yield does not directly reflect the current Federal Reserve policy rate.

Broadly speaking, the 10-year Treasury yield can be divided into the following two components:

US 10-year Treasury yield ≒ Average expectation of short-term rates over the next 10 years + Term premium

The average expectation of short-term rates is the outlook that market participants have priced in regarding what kind of monetary policy the Fed will implement in the future.

On the other hand, the term premium refers to the additional yield investors demand for holding government bonds over a long period. It is easy to understand if you think of it as compensation for taking on the risk that future interest rates will deviate from expectations and the risk of bond price fluctuations.

For example, if the average expectation for short-term rates over the next 10 years is 4.0% and the term premium is 1.0%, the 10-year Treasury yield will be 5.0%.

If expectations for additional Fed rate hikes recede here and the average expectation for short-term rates falls to 3.8%, the 10-year Treasury yield will fall to 4.8%, provided the term premium remains unchanged.

Conversely, even if the future policy rate outlook does not change, if the term premium rises to 1.3% due to concerns over the expansion of the fiscal deficit or increased issuance of government bonds, the 10-year Treasury yield will rise to 5.3%. The sharp rise in Japanese interest rates following the inauguration of the Takaichi administration after last October’s LDP presidential election can be considered to be due precisely to this rise in the term premium.

Even at the same 5% interest rate level, the implications for the market differ significantly depending on the breakdown.

🌶️ ② Three reasons why US interest rates fell despite the upward surprise in inflation

So, why did US long-term interest rates fall this week despite the upward surprise in inflation indicators?

There are three main factors to consider.

1. Demand for safe assets due to falling stock prices

First is the risk-aversion movement following the sharp drop in AI-related stocks.

On the 15th, the Nikkei Stock Average fell by 4.90% and the South Korean KOSPI fell by 7.57%. Concerns over the profitability and financing of AI-related companies intensified, leading investors to reduce equity risk and shift funds into relatively safer government bonds.

When bonds are bought, their prices rise and yields fall.

For this reason, even if inflation indicators come in higher than expected, long-term interest rates can fall if concerns about stock market declines and economic slowdown intensify even more.

2. Future economic slowdown and receding expectations for rate hikes

Second is the impact of financial market instability on the future economy and monetary policy.

Even if the Fed does not raise policy rates, financial conditions tighten if corporate financing costs rise due to higher long-term interest rates or widening credit spreads.

If mortgage rates remain high, housing demand is suppressed, and if corporate borrowing rates rise, capital investment is likely to slow down.

In such an environment, even if inflation is high, the need for the Fed to rush into additional rate hikes may decrease.

This week, Fed officials also made comments mentioning the demand-suppressing effects of rising long-term interest rates. If the market lowers its expectations for the terminal policy rate, downward pressure is placed on long-term interest rates.

3. Covering of short positions in bonds

Third is the adjustment of investor positions.

Investors who were short on bonds in anticipation of rising US long-term interest rates may buy back bonds to limit losses once interest rates begin to fall. This buying back can trigger further bond purchases, accelerating the decline in interest rates over a short period.

In particular, after a long period of rising interest rates, short positions in bonds may have accumulated. In such situations, the bias in positions can drive short-term price movements more than economic indicators themselves.

However, it is impossible to determine exactly which factor explains how many basis points of the current decline in interest rates without checking government bond futures open interest and term premium estimates.

🌶️ ③ Is a decline in interest rates really a positive factor for the stock market?

Generally, a decline in interest rates is considered a positive factor for the stock market.

This is because the discount rate used to discount future earnings to present value decreases, which tends to boost stock prices, especially for companies with high growth expectations.

However, there is a pitfall here as well.

Depending on ‘why’ interest rates have fallen, the impact on stock prices can be the exact opposite.

For example, if inflation slows down steadily and the Fed can ease monetary tightening while the economy remains robust, a decline in interest rates is a positive factor for the stock market.

While corporate earnings forecasts are maintained, the discount rate decreases, making it easier for stock prices to rise.

On the other hand, the situation is different if interest rates are falling due to an economic recession or corporate credit concerns.

Even if the discount rate falls, if the future earnings of companies themselves decrease, stock prices may decline.

This distinction is also important when considering the recent correction in AI-related stocks.

If interest rates fall while AI-related companies maintain their capital expenditure plans and concerns about profitability ease, it will likely support a rebound in stock prices.

However, if the funding environment for AI infrastructure companies deteriorates and a reduction in capital expenditure leads to a decrease in orders for semiconductor manufacturers, a decline in interest rates alone may not be enough to support stock prices.

It is necessary to judge not just by looking at the level of interest rates, but by combining it with trends in corporate earnings and the credit market.

🌶️ ④ What is the impact on the dollar-yen? ‘Falling US interest rates’ does not always mean ‘a stronger yen’

Changes in long-term interest rates also have a major impact on the foreign exchange market.

In general, if US interest rates fall and the interest rate differential with Japan narrows, the dollar’s appeal in terms of interest rates decreases, and downward pressure on the dollar-yen is likely to increase.

In fact, the dollar-yen fell to as low as 157.55 yen on the 15th.

However, the background of the interest rate decline is also important here.

If expectations for additional Fed rate hikes recede due to slowing US inflation, US interest rates and the dollar are likely to fall simultaneously.

On the other hand, if US Treasury bonds are bought due to global financial instability, the dollar may rise due to increased demand for the dollar as a safe-haven asset, even if US interest rates fall.

Furthermore, the dollar-yen is influenced not only by the US 10-year interest rate but also by the short-term interest rate differential between Japan and the US and the outlook for the Bank of Japan’s monetary policy.

Currently, while speculation is growing that the Bank of Japan will pass on a rate hike in October, the path toward normalization of monetary policy itself is seen as being maintained.

Going forward, if expectations for additional US rate hikes recede and expectations for Japanese rate hikes are maintained, upward pressure on the yen may strengthen through the narrowing of the Japan-US interest rate differential.

Conversely, if US inflation re-accelerates due to factors like rising crude oil prices and expectations for Fed rate hikes rise again, the downside for the dollar-yen is likely to be supported.

👀 Future Focus | Will the US 10-year yield fall below 5%?

When considering the future of US long-term interest rates, three scenarios can be envisioned.

In the first scenario, a combination of slowing inflation and economic resilience could cause the US 10-year yield to fall below 5%, potentially having a positive impact on the stock market.

In the second scenario, US Treasuries could be bought due to an economic slowdown or expanding credit concerns, leading to a significant drop in interest rates. However, this is not necessarily a positive factor for the stock market, as concerns over corporate earnings would intensify.

In the third scenario, US long-term interest rates could rise again due to re-accelerating inflation from higher oil prices and concerns over the fiscal deficit. It is important to note that higher interest rates, particularly those driven by an increase in the term premium, tend to push up corporate financing costs and act as a headwind for the stock market.

Moving forward, it is important to check not only the Fed’s policy rate outlook but also the US Treasury term premium, corporate bond credit spreads, and corporate earnings forecasts together.

🌶️ Summary of the Holiday Special Edition

In the US Treasury market this week, the 10-year yield plummeted to 5.06% despite a series of higher-than-expected inflation indicators.

This movement might seem puzzling at first glance. However, if you understand that long-term interest rates are formed by future policy rate expectations and the term premium, it is by no means a contradictory phenomenon.

And when thinking about the future of the financial markets, the most important thing is not just whether interest rates go up or down, but ‘what is causing the interest rates to move’.

While a decline in interest rates due to slowing inflation tends to be a tailwind for the stock market, a decline in interest rates due to economic slowdown or credit concerns may instead be accompanied by a fall in stock prices.

Whether the US 10-year yield falls below 5% is important, but more than that, it is necessary to determine whether the background of the interest rate decline is economic stability or instability in the financial markets.

Look at the reasons moving interest rates, not the direction of the rates.

Isn’t that an important perspective for interpreting the future of the stock and currency markets?

Financial markets, in 3 minutes for busy people.

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