Treasury Yields Continue to Climb Following Positive Economic News

The bond market was quite active on Wednesday, though perhaps the participants aren’t really vigilantes after all.

The yield on the 10-year Treasury reached 5.108 percent, marking its highest point since 2007. If this increase was supposed to signal concerns about Washington’s debt, the timing was a bit strange. The decline in bond prices occurred after a report indicated that American businesses are expanding at a much quicker pace than economists had anticipated. There wasn’t any news related to the federal deficit or national debt at that time.

A preliminary survey from S&P Global for September noted that activity in both manufacturing and services was growing at the fastest rate in over five years. The composite index rose from 56.0 in August to 58.4. Additionally, the manufacturing index increased to 57.0 from 53.9, surpassing expectations of 53.6, while the services index climbed to 58.7. Both new orders and hiring showed signs of strengthening. According to S&P Global, these September figures indicate potential annualized growth of around five percent for the month and four percent for the third quarter. The Atlanta Fed’s GDPNow estimate had already projected a growth rate of 5.1 percent for the quarter prior to this report.

“US business remains robust, achieving its fastest output growth rate in over five years in September,” commented Chris Williamson, an economist at S&P Global.

Stronger Growth Expectations Driving Yield Increases

The bond market reacted quickly to this news. As yields ticked upward across the Treasury landscape, traders ramped up their expectations for another potential Federal Reserve rate hike in October. Initially, futures indicated a 53 percent chance of a rate increase, but that number surged to 73 percent following the news. The yield on the two-year Treasury, which closely follows Fed policy expectations, also went up alongside the 10-year yield.

This scenario serves as a test of the theory that rising Treasury yields are primarily a reflection of so-called bond vigilantes scrutinizing federal borrowing. There wasn’t a sudden rise in government debt right after the PMI numbers were released. Instead, it seemed that investors adjusted their views based on the strength of the economy, leading them to revise their interest rate expectations.

But just because bond traders are reacting to this economic growth doesn’t mean they’ve ignored inflation. Participants in the S&P survey did mention increasing input costs, which could be attributed to higher energy prices. Stronger demand might also lead the Fed to feel less assured that inflation will return to its two percent target anytime soon. Consequently, a robust growth report could also suggest a tighter monetary policy ahead. Moreover, the solid rate of business growth hints at minimal downside risk for a Fed rate hike at this moment, paving the way for potential increases. Yet, this thought process stems from positive economic news rather than a fresh evaluation of the government’s borrowing capabilities.

Barr’s Economic Insights

On Wednesday, Federal Reserve Governor Michael Barr made some optimistic comments regarding the economy. He highlighted that persistent inflation poses a significant risk due to the solid state of economic growth.

“The economy is growing strongly, and the labor market is solid, but inflation is exceeding our two percent target and isn’t clearly trending toward it quickly. Moreover, the likelihood of achieving our inflation target has increased, while the risks to the labor market have lessened. We need to adjust monetary policy to better align with the risks related to our objectives,” Barr stated in a speech at the Chicago Fed.

The movement in shorter-term bonds helps clarify the situation. If the sell-off from Wednesday was primarily related to increasing long-term Treasury supply or the risk premium for those investments, we would expect the pressure to be felt mostly at the long end of the market. Instead, the two-year yield rose about the same amount as the 10-year yield in the immediate aftermath. Traders were re-evaluating the anticipated path of Federal Reserve policy.

In essence, the Treasury sell-off represents good news rather than bad. The economy produced a significant surprise on the upside, prompting investors to believe that the Fed might raise rates again. Consequently, Treasury prices decreased. The bond market was responding to the economy’s strength, and the route from the economic report to the higher yields was directly linked to expectations for the Fed.

This situation reflects not bond vigilantes, but rather bond market observers closely following the accelerating engines of economic growth.