The 10-Year Treasury Yield Tops 5%. Now What?

Susan Dziubinski: Now the yield on the 10-year Treasury bond crossed 5% for the first time since 2007. Do you expect the yield to rise much further?

Dave Sekera: Good morning, Susan. Usually, I steer away from making those short-term predictions, but I will say, in this case, I don’t think the 10-year is really going to rise that much above 5%. There’s a couple of reasons for this. First, there are just a lot of technical factors that are hitting the bond market right now. For example, we still have the Fed’s ongoing quantitative-tightening program. We also have higher-than-expected U.S. deficit financing needs right now. And also I’ve been hearing reports of a lot of foreign investors and central banks selling as well. And then just thinking about going forward, as the 10-year does rise further and further above 5%, I think you’d see a lot of new buyers really start emerging, including insurance companies and pension funds. The type of buyers would see that as a very attractive opportunity to duration-match their asset and their liabilities.

Plus, when it just gets above 5%, I just think a lot of people are going to really start seeing that as being much more attractive, especially in the corporate-bond market. I was taking a look this morning, the Morningstar investment-grade bond index now yields 6.25%, and our high-yield bond index is all the way up to 9.4%. And then lastly, thinking about it from a fundamental longer-term perspective, our U.S. economics team is forecasting that the economy is starting to slow and that growth rate is going to slow for the next three quarters. While our base case is no recession, that combination of that and then also the expectation that inflation will continue to slow, I think that combination is going to give the Fed the room that it needs to start cutting short-term interest rates next year.

Dziubinski: What does this mean for the stock and bond markets, Dave? What should investors be making of this?

Sekera: For investors, I think now is a really great time to make sure you reevaluate the allocations in your portfolio, both between the percent that you have in fixed income as well as the percent you have in equity, but also in the duration in your fixed-income allocations. I think now is a good time to start extending that duration further out on the yield curve, lock in those higher rates. Part of the reason is that we do expect short-term rates, while they look high now, will start coming down next year. Our economics team is forecasting that the Fed will cut the fed-funds rate by 175 basis points over the course of 2024. And then from an equity valuation yield perspective, I think that will put a negative sentiment on the equity market over the next couple of months. I think those higher rates will be a headwind until the market really sees the economy bottoming out, probably middle of next year, and beginning to expand thereafter.

This is an excerpt from this week’s episode of Monday Morning Markets with Morningstar’s Dave Sekera. Watch the full episode, 4 Undervalued Stocks to Buy After Earnings. See a list of previous episodes here.