Rising US Interest Rates: The 10-Year Is 'Not' What You Should Really Be Watching—What the -Year and -Year Rates Reveal
Former Bank of Japan official, PhD in Mathematics from the University of Tokyo, and former Chief Fixed Income Strategist at Nomura. First person in history to rank 3rd in two categories (Bonds and Securitization) in the Nikkei Veritas analyst rankings. Based on my experience of making 400 proposals a year to institutional investors, I deliver the ‘essence of finance’ that bankers and securities professionals can use directly in client conversations and internal presentations. All past articles are available exclusively to members (free articles move to members-only status two days after publication).
US 2-year, 10-year, and 30-year—even though it is the same ‘rise in US interest rates,’ the reasons differ completely depending on the maturity. In this article, I will break down the factors to clarify ‘why US interest rates are rising’ and the ‘outlook for US interest rates.’
Since the beginning of this year, US Treasury yields have risen significantly.
While the benchmark 10-year US Treasury yield attracts the most attention, the 2-year and 30-year rates are also rising.
Now, did you know that even though we refer to them collectively as US Treasury yields, the reasons for the rise differ by maturity?
Fiscal concerns are often cited as a reason for the rise in US interest rates, but in reality, that also depends on the maturity.
‘When a client asks you, “Why are US interest rates rising?” what do you answer?’
In this article, I will break down US interest rates by maturity and provide a rough explanation of ‘why US interest rates are rising’ and ‘where US interest rates are likely to settle.’
■ US interest rates can be broken down into two factors
Now, here is a graph of US interest rates. As mentioned at the beginning, they have risen significantly across all maturities.
Now, USinterest rates can be broken down into rate hike expectations and factors other than rate hike expectations (such as supply and demand factors).
Of these, the portion excluding rate hike expectations (such as supply and demand factors) is called the ‘term premium.’
US interest rates = rate hike expectations + term premium
‘Fiscal concerns’ and ‘moving away from US Treasuries’ are reflected in this term premium.
For concerns regarding US fiscal policy, please refer to the following article (I will summarize the topic of moving away from US Treasuries in a future article).
■ Let’s break it down by maturity
Let’s immediately break down US interest rates by maturity.
We will look at them in order of maturity: 2-year, 10-year, and 30-year.
US 2-Year Rate—Almost Entirely Rate Hike Expectations
First, the US 2-year rate.
Although it is rising, it is at the same level as the highs seen in 2023–2024, and unlike the US 10-year rate, it is not at a multi-decade high.
Breaking down the US 2-year rate, we can see that it is rising almost entirely due to rate hike expectations (risk-neutral yield).
This makes sense. Since the principal of a 2-year US Treasury bond is returned after holding it for two years, its rate is determined by comparison with the policy rate, barring any extreme circumstances.
Roughly speaking, it is the feeling of asking, ‘Which is more profitable, a bank deposit or a 2-year government bond?’
The 2-year rate usually only rises due to factors other than rate hike expectations when a sovereign default is feared, such as with Greek government bonds during the European debt crisis.
US 10-Year Rate—Both Rate Hike Expectations and Term Premium
Next is the US 10-year rate.
We can see thatboth rate hike expectations and the term premium are factors driving the interest rate higher.
It is easier to see which has a greater impact by looking at this graph, which sets the left side to zero.
Looking at the past year, the rise in rate hike expectations pushed the US 10-year rate up by 0.7 percentage points, with the remaining 0.3 percentage points being due to the term premium factor.
US 30-Year Rate—Almost Entirely Term Premium
Finally, the US 30-year interest rate.
I have been using the New York Fed’s estimates for term premiums so far, but since the New York Fed does not publish them for the 30-year, I calculated them myself.
Here are the results.
The recent rise in the US 30-year interest rate can be explained almost entirely by the term premium (supply and demand factors).
■ Summary: Which interest rates should you watch?
To summarize the above—
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The rise in the US 2-year rate is ‘almost entirely due to rate hike expectations’
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The US 10-year rate is ‘a mix of both rate hike expectations and term premiums’
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The US 30-year rate is ‘almost entirely due to term premiums’
While it is time-consuming to check rate hike expectations or US Treasury term premiums (supply and demand factors) yourself, charts for the US 2-year and 30-year rates are easy to find with a search.
Therefore, you should look at the US 2-year rate to see if rate hike expectations have risen or fallen, and look at the US 30-year rate for term premiums.
(Note) While the values for rate hike expectations and term premiums differ by maturity, checking the US 2-year and 30-year rates is a good way to monitor the trends of rate hike expectations and term premiums for ‘US Treasuries as a whole’.
■ Thinking about future US interest rates
Finally, let’s consider future US interest rates using term premiums.
‘If concerns about US fiscal policy intensify further, how high could the US 10-year rate go?’
The recent term premium for the US 10-year rate is estimated by the New York Fed to be around 0.9%. The peak for the term premium was 3.4% in October 2008.
Therefore, a simple calculation suggests a scenario where it rises by 3.4% − 0.9% = +2.5% from here, pushing the US 10-year rate into the high 7% range.
However, this is only if expectations for rate hikes remain unchanged. Normally, when fiscal conditions deteriorate to this extent, it also has a negative impact on the economy, so it is thought that rate hike expectations will decline, and the US 10-year yield will be pushed down by that amount.
Also, since the term premium is merely an estimated value, this figure should be treated only as a reference.
“So, what about the direction of falling interest rates?”
It seems that US fiscal concerns are not likely to subside easily. In that case, a decline in US interest rates would mean a retreat in rate hike expectations.
Regarding the US 10-year yield, the recent rate hike expectation portion is about 4.2%. At the end of last year, before interest rates rose, it was about 3.5%.
Therefore, if rate hike expectations return to the level of the end of last year, the US 10-year yield will fall by 4.2% – 3.5% = 0.7%, so the calculation is that the US 10-year yield will fall to about 5.2% – 0.7% = 4.5%.
If not only the cooling of inflation but also an economic recession is priced in, the US 10-year yield will decline further, but in that case, it is necessary to keep a close watch on whether concerns about fiscal deterioration will increase.
Thank you for reading to the end. Since free articles become unavailable two days after publication, if you would like to see past articles, I recommend joining the membership. Takenobu Nakajima’s Money.lab | Takenobu Nakajima (Former Bank of Japan official, PhD in Mathematics from the University of Tokyo)