There’s More Behind the Rise in Treasury Yields

There’s more behind the move in Treasury yields

Last week’s U.S. employment report provided an encouraging signal about the underlying economy. Nonfarm payrolls exceeded expectations, while unemployment held at 4.1%. Wage growth moderated slightly to 3.1% year over year from 3.2%.

As Nelson explains, that combination points to a labor market that remains resilient without generating an especially concerning wage inflation signal. On its own, the report supports a healthy growth outlook while strengthening the case for keeping interest rates steady.

But there is more behind the rise in long-term yields than expectations for the Federal Reserve. The move above 4.9% also reflects a higher term premium, as investors demand additional compensation for uncertainty around inflation, fiscal policy and government bond issuance.

Oil reinforces those concerns. Even if underlying inflation continues to moderate, crude prices above $100 per barrel increase the risk that headline inflation remains elevated for longer. That means even relatively benign inflation data may not be enough on its own to push longer-term Treasury yields meaningfully lower.

Central banks confront a common challenge

The pressure on rates is not confined to the U.S. The European Central Bank raised rates by 25 basis points this week, marking its second increase of the year. Markets are also anticipating further tightening from the Bank of Japan as higher energy and import costs add to inflation pressures.

The common thread is that central banks are balancing relatively resilient economic activity against inflation that has yet to fully settle.

For investors, those regional differences also matter. The timing and extent of further tightening could vary significantly across economies as policymakers respond to their own mix of growth and inflation pressures.

Inflation remains key to the Fed outlook

At the end of the week, attention turned to the August Consumer Price Index (CPI) report, one of the most important remaining inputs before the Federal Reserve’s September 15-16 meeting. Headline CPI rose 0.4% in August and 3.4% year over year, reflecting in part the impact of higher energy prices. Core CPI rose roughly 0.3% month over month, slightly above consensus expectations, while holding steady at 2.4% year over year.

Ahead of the report, Nelson viewed a core CPI reading of 0.2% month over month or lower as strengthening the case for the Fed to remain on hold, while a reading of 0.3% or higher would make the argument for another increase more compelling. Markets responded accordingly. Futures had been pricing roughly a 70% probability of a rate increase on Thursday, but following Friday’s CPI report, those odds jumped to nearly 90%.

Taken together, the results leave the Fed with a mixed inflation picture. Higher energy prices are contributing to headline inflation, while the core reading adds to the case for further tightening. At the same time, core inflation remains steady on a year-over-year basis. Uncertainty around energy, fiscal policy and bond supply could also keep longer-term yields elevated.

For investors, the bigger story is about more than the Fed’s next decision. Resilient growth, energy prices, inflation and the compensation investors demand for holding longer-term bonds are all shaping the rates outlook.

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