Rising Expectations of Higher Interest Rates

The yield of the 10-year U.S. Treasury, which serves as the benchmark for mortgage rates, has reached its highest level in 2023. This comes as expectations grow that the Federal Reserve will maintain higher interest rates in order to combat inflation.

On Tuesday, the yield on the 10-year Treasury surpassed 4.23%, marking its highest level since November of last year. Prior to the release of the latest consumer-price index (CPI) data, which revealed an end to a series of declines in inflation, the yield stood at 4.02% last Thursday.

Deutsche Bank analyst Henry Allen commented on the situation, stating that borrowing costs are becoming more restrictive in real terms. He pointed to the Federal Reserve's potential decision to prolong restrictive policies as a key driver behind the upward trajectory of yields. Allen noted that markets are reassessing the policy path in a more hawkish direction.

With the latest CPI print showing a year-over-year increase of 3.2%, concerns are mounting that the era of slow price growth may be coming to an end. Inflation remains well above the Federal Reserve's target of 2%. As a result, Treasury yields have been steadily rising across the board and traders are placing bets on a more aggressive Fed.

Futures markets currently indicate a higher probability that the Fed will maintain rates at the current level of 5.25%-5.5% for an extended period or potentially even raise borrowing costs further.

The CME FedWatch Tool reveals that compared to a week ago, there is an increased likelihood that rates will remain at their current high level during the January, March, May, or June 2024 meetings of the Fed's monetary policy committee. The same market metric also shows that chances of a quarter-point hike have nearly doubled since last week. There is now a 25% chance that the upper bound of rates will rise to 5.75% by January, up from a previous 16% chance.

As Treasury yields remain elevated, stocks are experiencing downward pressure and investor sentiment is dampened, as evidenced by the losses in the Dow Jones Industrial Average and S&P 500. If expectations of higher rates being sustained for a longer period materialize, mortgages may also face increased pressure.