What US Treasury Volatility Means for the Economy

Last week’s sharp moves in the US government bond market have people wondering about the implications not only for the outlook for other financial assets, including stocks but also for the economy and policy. Here are my main takeaways and their consequences:

The volatility last week differed from that of 2022 and earlier this year because it was driven not by the policy-sensitive short end of the yield curve (such as the two-year Treasury) but by the longer-dated bonds. The yield on the 10-year note surged from 3.92% to 4.19%, retracing to 4.03% on Friday, while the yield on the 30-year bond rose from 4.03% to 4.20%, hitting a weekly high of 4.31%. This shift in drivers suggests a stronger convergence within markets on the Federal Reserve’s likely interest-rate path in the immediate future along with a broader range of factors influencing the long-term maturities.

The wider set of factors includes four domestic ones and a more uncertain international overlay.

Two dominant domestic factors are likely to have more lasting effects: the market’s adjustment to the prospects of significantly higher debt sales by the US government, especially in the midst of the shift by the Fed from quantitative easing (QE) to quantitative tightening (QT); and a growing understanding that current inflation dynamics will translate into higher interest rates for longer than markets had anticipated. Both these factors are likely to continue to contribute to volatility going forward.

The other two domestic factors are likely to be of less significance. This is especially the case for the downgrade of US sovereign debt by Fitch Ratings, whose importance has been dismissed by many economists and market participants. As to the economy’s growth outlook, the fourth factor, most forecasts already reflect the greater likelihood of the US avoiding a recession this year absent another policy mistake.