Rate normalization and the return of risk

REAL ECONOMY BLOG | January 08, 2024

Authored by RSM US LLP

Financial markets had a difficult start to the year after an exuberant end to last year.

The yield on 10-year Treasury bills dropped from 5.0% to 3.8% to end the year as investors priced in an early start for monetary policy easing.

Now, as the Federal Reserve signals rate cuts, we think conditions are ripe for the yield curve to continue to normalize as the long end moves to a range between 4% and 4.25%.

It’s all part of a rising appetite for risk that is likely to spill over into private equity as a wave of refinancing arrives in commercial real estate and corporate debt starting this year.

Money markets have stabilized, thanks to the Treasury Department and Federal Reserve navigating the debt-ceiling standoff, and it is probable that some of the cash that flooded into money market funds last year will spill over into asset markets. That shift will mark a change from the recession-driven narrative that permeated financial markets over the past year.

It took the better part of last year for the RSM US Financial Conditions Index to recover from this year’s debt-ceiling standoff.

Our index is now slightly negative. That implies residual tightness in the fixed-income markets, which makes it more expensive to attain financing. We think that this too will improve in the coming months and is part of the foundation for our budding optimism.

The yield curve normalizing

Six months ago, the Federal Reserve was still hiking its policy rate. The yields on two-year Treasury bonds were roughly 4.75%, an abnormal 75 basis points higher than five-year yields, which were at 4.0%.

With 10-year yields even lower at 3.75%, the yield curve was inverted as the market priced in the potential of an economic slowdown or a full-blown recession.

That was before the remarkable resilience of the U.S. economy became fully apparent.

Our modeling work suggests that the U.S. economy grew by 2.5% last year and is poised to slow to its long-term rate of 1.8% per year. That implies an economy able to support long-term interest rates in the range of 4.0% to 4.5% this year and next.

Now. with inflation receding and the economy operating at full employment, the Fed has signaled its intention to lower its policy rate toward a target of 4.6% this year, 3.6% next year and 2.5% in the longer run.

And because two-year bond yields are determined by the expected path of the federal funds rate, we can expect the front end of the yield curve to become steeper, with two-year yields dropping below five-year and 10-year yields.

A dose of reality

The spectacular run of the stock and the bond markets last year reflects confidence in the economic recovery. But trading in the first week of January suggests that markets may have gotten ahead of themselves.

In the first week of January, the S&P 500 index gave back 1.5% of last year’s gains. And 10-year bond yields traded back above 4.0% as the market factored in the uncertainty over the start date for Fed easing.

In our view, the Fed is faced with balancing the risk of lingering inflation, which would require maintaining the policy rate at 5.5%, versus the risk of a government shutdown and geopolitical shocks that would dampen the recovery and require quick rate cuts.

The bond market often undergoes large swings in 10-year yields within long-term trends, which directly affect the cost and availability of corporate borrowing. We expect 10-year Treasury notes to trade within a 4.0% and 4.5% range as the economy progresses and as monetary policy normalizes.

A return to normal

The Fed’s reverse repo facility was created during the financial crisis and designed to maintain liquidity in the money markets. Money market funds could park cash in the facility and receive an overnight return even during periods of crisis.

But investors are now drawing down their money market funds as they look to receive comparable rates now available over a longer time period in Treasury bills.

This drawdown will add pressure on the Fed, which hinted in its December minutes that it may need to reduce the runoff off its balance sheet, known as quantitative tightening, and ease liquidity concerns in the repo markets.

A bit of caution in credit markets

Credit default swaps allow the transfer of risk from one party to the next, in effect creating an insurance policy for debt holders.

The large increase in the cost of insurance early last year dissipated as the risk of a government default and bank failures eased, only to increase again as threats of government shutdown returned.

In the first week of this year, the risk of another economic shock has kept the cost of insurance elevated.

The takeaway

After a year of spectacular returns, investors have reassessed some of that exuberance in the first week of January, which should continue.

Minutes from the Federal Reserve indicate that market expectations of rate cuts starting in March need to be pared back. We think that the start date is more likely in June as long as the inflation outlook improves.

We are forecasting the 10-year yield to trade around 4.25% this year, with action at the front end of the curve as the Fed cuts rates in the second half.

As rates come down later this year, we expect a pickup in deals around the stress in commercial real estate markets and as smart money moves ahead of the wave of corporate debt refinancing that will hit in 2025 and 2026.