The U.S. bond market has been experiencing a period of heightened volatility, driven by a surge in 10-year Treasury yields following the recent FOMC meeting. This upward pressure, coupled with a jump in interest rate volatility and a shift to positive term premiums, signals significant shifts in market dynamics. In this analysis, we explore the key factors behind these developments and consider the potential implications ahead of the U.S. elections.

Bracing for the Unexpected: Navigating the Bond Market's Turbulent Landscape

The Bond Market Shake-up: Unraveling the Driving Forces

Since the Federal Reserve's September meeting, 10-year Treasury yields have spiked nearly 60 basis points. This increase reflects a confluence of factors, including stronger-than-expected U.S. macroeconomic data, commodity price inflation fueled by Chinese stimulus measures, and recent statements by Fed policymakers advocating for a higher terminal rate. The rising political uncertainties, particularly the increasing probability of a Republican "sweep" (presidency, Senate, and House), have further added to the market's anxieties. Investors are bracing for the prospect of new tax cuts and a potentially ballooning federal deficit – both factors that historically contribute to upward pressure on bond yields and the Term Premium.

Positive Term Premiums and Bond Market Tensions: Deciphering the Dynamics

The surge in Treasury yields can be attributed to several key factors. First, the revaluation of the terminal rate, with the expected terminal rate moving from 2.7% to 3.4% within a month, aligning with recent comments from Atlanta Fed President Raphael Bostic. This shift reflects the market's perception of a "soft landing" scenario, implying a higher "neutral rate" for the economy.Second, breakeven rates, which serve as a proxy for inflation expectations, have been influenced by rising geopolitical tensions and Chinese stimulus. The 10-year breakeven rate has jumped from 2.05% to 2.32% over the past month, nearing 2024 highs, despite the easing of oil prices.Third, the term premium, or the extra yield investors require to hold longer-term Treasuries, has turned positive, reaching a high for 2024. Typically low since the 2008 financial crisis due to liquidity injections, the term premium has risen by 50 basis points, with Cross Border Capital attributing 70% of this to bond volatility, 10% to inflation risk shifts, and the rest to changes in supply and demand dynamics.Finally, the spike in interest rate volatility, as evidenced by the MOVE index hitting a one-year high on October 7, reflects heightened political anxiety around future yields. This marked the first time that one-month options extended beyond the election date, underscoring the market's heightened sensitivity to the potential outcomes.

Yield Curve Dynamics: Navigating the Shifting Landscape

If the Federal Reserve proceeds with two additional 25-basis-point rate cuts by the end of 2024, as the market anticipates, we could see a yield curve steepening of approximately 70 basis points. This would align with the current 10-year U.S. Treasury yield of around 4.2%, close to the historical average of 80 basis points.Notably, the 10-year U.S. yield has surged by 60 basis points in recent weeks, as markets increasingly expect a Trump victory with a Republican majority across the presidency, Senate, and House. Unlike in 2016, when Trump's election was a surprise that drove the 10-year yield up by 80 basis points, this time, markets are more prepared, and the adjustments are less abrupt but still impactful.From a valuation perspective, and given the current economic cycle, a 10-year yield at 4.2% approximates its fair value within a context where a Republican victory is plausible. The recent repricing pressure on the terminal rate seems to be reaching its peak, and breakeven rates have decoupled from oil prices, which have recently softened. This divergence is unusual, as breakevens typically mirror movements in commodity prices like oil.

Election Implications: Navigating the Potential Policy Shifts

In our recent report on the implications of the U.S. elections on the bond market, we highlighted that a Trump presidency would likely involve more aggressive fiscal expansion through significant tax cuts, increased defense spending, and potentially new tariffs. Such policies could increase inflationary risks, which would limit the Federal Reserve's capacity for deep rate cuts. In this scenario, the yield curve could steepen further, with long-term yields rising more sharply due to heightened inflation expectations and a higher term premium.Fiscal expansion and potential trade disruptions from tariffs could further accelerate inflation, driving yields higher as investors demand additional compensation for heightened risks. At this level, additional basis points could still be added, justified by the compounded uncertainties surrounding future U.S. Treasury supply and the anticipated expansionary fiscal policies.The combination of elevated fiscal spending and potential supply-driven inflation risks could lead to further upward pressures on long-term yields in the bond market. However, a divided government would constrain fiscal expansion, complicating the passage of significant spending measures, potentially stabilizing or slightly reducing yields. Weaker-than-expected macroeconomic data could also prompt a more cautious policy response, delaying or scaling back anticipated fiscal changes, further alleviating upward pressure on yields.