A just-published report examined the structural forces at work in the Treasury market, and the message was that there is more upside in yields over the long haul.
Both cyclical and noncyclical factors have driven Treasury yields higher over the past six months. This includes a rise in the term premium, possibly due to a greater than anticipated forthcoming supply of bonds. Moreover, the expected real policy rate has risen, implying that bond investors are raising their estimates of the long-term equilibrium rate or “R-star”. The latter was also evident in the latest Fed Summary of Economic Forecasts, where several participants raised their estimate of R-star.
Bond yields should remain under upward pressure as the bond market’s R-star is still lower than our estimate of its true value, while the term premium is still historically depressed and vulnerable to fears of a deteriorating fiscal outlook.
While the Treasury market is oversold and could consolidate for a time, yields have more upside as a resilient economy will eventually force investors and the Fed to abandon expectations for policy rate cuts next year.