The U.S. economy and financial markets are in the midst of a structural change.
Key takeaways
The economy will require higher interest rates to compensate investors for the rising risk in holding Treasury notes.
Nowhere is the new landscape better illustrated than in the widening U.S. 30-year less 10-year Treasury spread.
For the past three years, our core macro theme has been that of a regime change in the U.S. economy and financial markets.
That is, the economy will grow faster and require higher interest rates to compensate investors for the risk associated with holding long-term Treasury securities. This higher risk is driven by government policy that carries an inflationary bias, more than had been the case during the era of globalization in previous decades.
Now, as populist economics takes hold and globalization fades, nowhere is the new regime better illustrated than in the widening U.S. 30-year less 10-year Treasury spread in the bond market.
The increase in that often-overlooked spread suggests that the economy is set to grow faster, generate higher inflation and demand a higher policy rate from the Federal Reserve as long-term interest rates rise.
Unfortunately, we tend to look at this spread only when the economy and financial markets are stressed and reach inflection points.
In addition, the move reflects a change in investors’ perceptions around the safe-haven value of holding long-dated U.S. paper. The Fed has curtailed purchases of long-run assets, capital inflows have slowed and higher inflation has dented the credibility of dollar-denominated assets.
What’s more, investors are growing increasingly concerned around the intersection of government spending, taxes, trade, inflation and growth.
These changes are removing the anchor on which investors allocate risk capital. And that requires higher rates and is the major catalyst behind the nonvirtuous widening of that spread.
A quick look at the 30-year less 10-year spread provides some quick insights.
First, the spread is back to prefinancial crisis levels. The average spread stands at 48 basis points, just below the long-term average of 51, after briefly inverting in 2023. That points to normalization in the relationship between financial markets and the economy following an extended period of unorthodox monetary policy that suppressed rates at the long end of the curve.
Second, that normalization has not been well received by a generation of investors that grew accustomed to low interest rates. What makes it more challenging is the disruption caused by U.S. trade policy, which seeks to rebalance the global economy.
Selling at the long end of the curve has pushed the 30-year and 10-year notes higher, not for virtuous reasons around faster growth but rather because of risks around higher inflation and the need for higher interest rates to compensate for holding long-dated dollar-denominated assets.
The risks and opportunities around holding such debt explain the widening yield spread between the 30-year and 10-year.
A structural change is taking place in the market, forcing a general repricing of risk.
It is important to note that the spread is sensitive to changes in inflation expectations and monetary policy, which are clearly in flux.
Under current conditions, the widening spread tells investors they may not be adequately compensated for the duration of risk associated with holding long-dated financial instruments.
It is natural that information will, in turn, influence pricing and hedging strategies around long-term debt, mortgages and pension liabilities.
RSM contributors
