In May 2020, with the 10-year Treasury yielding 0.64 percent, we argued that a sharp repricing in government bonds is coming. Given the grim economic reality at the time, this seemed like a stretch but as we like to say, the future is not always a reflection of the present.

“What if the steep, dramatic decline in the US economy is followed by an equally rapid upturn?” we asked. “What if the unprecedented speed and scale of the fiscal and monetary response, plus the effects of a continued retreat from globalization, lifts inflation past the 2 percent target that the Fed has had a tough time attaining?”

With hindsight, the secular bull market in bonds probably ended when the 10-year yield fell below 0.5 percent on March 9, 2020. That doesn’t necessarily mean, however, that we are now in a secular bear market. We wouldn’t be surprised to see the 10-year yield range-bound between 1.5 percent and 3.5 percent for the rest of the decade. 

Reviewing past monetary cycles, we observe that the 10-year Treasury yield and the Fed funds rate have peaked around the same level. In 1989, the 10-year yield was constrained by a funds rate around 9 percent. In 2000, the 10-year yield and the funds rate peaked at 6.5 percent. In 2006, both topped at around 5 percent. 

The exception was in 1994 when bond yields spiked higher in response to the Fed’s shock tightening. Then Fed chief Alan Greenspan doubled the main policy rate from 3 percent to 6 percent over the course of a year, a move not built into market expectations. 

In 2018 most Fed officials thought the neutral rate was near 2.5 percent. The Fed was aiming to take rates above neutral and stop tightening at around 3 percent. As the 10-year Treasury was yielding 3.25 percent in October, we argued it was already pricing in future tightening.  

“If anything,” we wrote, “the interest rate cycle could end sooner—at a lower terminal rate—if the global economy slows further and financial conditions worsen.” The Fed stopped hiking in December after lifting the fed funds rate to 2.25 percent. That was the last great buying opportunity in bonds. 

Most Fed officials still believe the neutral rate is around 2.5 percent. The median FOMC projection for the terminal federal funds rate during this cycle is 2.8 percent. The markets anticipate that the fed funds rate will exceed 3 percent by early 2023. 

Even if we assume that the Fed’s terminal rate is 3.25 percent now, the 10-year Treasury yield could very well be near the peak level for this cycle, if history is any guide. 

It may be hard to believe that bond yields will decline in the face of aggressive rate hikes and quantitative tightening. But shouldn’t we anticipate the opposite of what happened during QE? Yields rose during each previous round of central bank bond buying. 

Let’s investigate further. Bond yields can be decomposed into expected short rates and term premiums. 

Term premia fell and finally vanished, spending much of the time between late 2014 and early 2021 below zero. That’s all changed now. The term premium that 10-year Treasury bonds offer has reverted to more normal levels of 0.66 percent. The all-time low in March of 2020 was -1.15 percent. According to one Fed model, it has averaged about 1.56 percentage points since 1961. 

The Fed’s QE program is expected to have reduced the term premium by 100 basis points, thus the current adjustment is reasonable. It’s unlikely that the Fed’s $9 trillion balance sheet will shrink all the way back to its pre-pandemic level of roughly $4 trillion. Therefore, we reckon the term premium won’t return to historical levels.  

Short-rate expectations are unlikely to be revised much higher given our inflation outlook. The 10-year breakeven inflation rate moved up to 3 percent in April before slipping back to 2.75 percent. The long-term average is 2 percent. We see more downside in this measure. Inflation data is moving from a tailwind for higher yields to a headwind. 

Monthly core inflation slowed for the second month in a row—from 0.5 percent in February to 0.3 percent in March. For context, the headline rate was boosted by a 32 percent increase in energy and an 8.8 percent increase in food. On a year-over-year basis, core PCE inflation declined to 5.2 percent from 5.3 percent in the prior month. 

Average hourly earnings for all workers rose 5.5 percent through April compared to a year ago. However, the 3-month wage inflation rate has been falling below this level for the past three months and was down to 3.7 percent in April. The same can be said for the 3-month wage inflation rate in goods-producing industries at 4.1 percent versus 5.2 percent year-over year and in service-providing industries at 3.6 percent versus 5.6 percent year-over-year.

“We’re at peak or have passed the peak of wage inflation in the US,” says ManpowerGroup CEO Jonas Prising. “It’s still high but when we look at some of our most recent trends, we can see some easing off in the growth rates, which we believe is positive overall.” 

How do we reconcile our contrarian view with the popular opinion, which holds that we are in a new inflationary paradigm and that yields have secularly broken out? There is a flaw in this analysis, given the repeated “false breakouts” in the 10-year yield throughout the years.

The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity. A failed break occurs when a price moves through an identified level of support or resistance without enough momentum to carry onward in its direction. Since the validity of the breakout is compromised, this is commonly referred to as a “false breakout” and price reverses in the opposite direction. 

The third point on the trend line connecting the October 1987 peak and October 1994 peak was 6.6 percent. But the 10-year yield broke above to 6.8 percent in January 2000 and then fell to 4.9 percent a year later and 3.5 percent by June 2003. 

The third point on the trend line connecting the October 1994 peak and the January 2000 peak was 5 percent. The 10-year yield jumped to 5.3 percent in June 2007 and then fell to 2 percent in December 2008. 

The third point on the trend line connecting the January 2000 peak and the June 2007 peak was 3 percent. After an initial attempt in May 2018, the 10-year yield broke above to 3.25 percent in October. It fell to 2 percent a year later.

The third point on the trend line connecting the April 2010 peak and the October 2018 peak is 3 percent. The 10-year yield recently jumped to 3.16 percent. Another failed break? The quarterly rate of change is off the charts and the monthly RSI of 76 is equivalent to the overextension during previous yield peaks. 

In the middle of a sharp bond sell-off, it’s simple to stay short. When markets begin to consolidate, though, the cost of carry generates a lot of mental strain. Shorting the 10-year Treasury currently costs roughly 30 basis points, implying a breakeven rate of 3.3 percent. If bond yields rise to 3.5 percent, you’re playing for just 20 basis points. That’s a tough bet.