Bond Market Returns to Normal as Rates Align with Historical Averages

After years of near-zero interest rates that left retirees and pensions struggling, the bond market is gradually returning to a more balanced state. The current US interest rates are considered normal, with short-term rates slightly elevated due to higher inflation and long-term rates aligning with historical averages. The bond market operates on a principle where short-term rates add about 1% to inflation to encourage saving, while long-term yields add another percentage point to motivate long-term lending. This equilibrium typically results in a 10-year Treasury yield of 4 to 5%, which is slightly below the current yield.

The bond market naturally corrects itself when yields drift too far in either direction. Higher rates attract buyers, pushing yields down, while lower rates prompt investors to seek higher returns elsewhere, lifting yields up. This dynamic also affects prices of assets like homes, college tuition, and private company stakes. With rates returning to normal levels, signs of slowing demand in the housing market, struggles in expensive universities, and difficulties in selling private businesses are already emerging.

Contrary to popular belief, the Federal Reserve does not control interest rates but rather follows the cues from short-term Treasury yields. For instance, the two-year Treasury yield recently surpassed the federal funds rate, signaling that the Fed would need to raise its benchmark rate to combat inflation. The Fed's preferred inflation gauge, core personal consumption expenditures, has remained above 3% since spring, prompting a rate hike in September. The two-year Treasury yield is now at 4.9%, a percentage point higher than the fed funds rate, reflecting the market's focus on curbing inflation.

Despite efforts by Treasury Secretary Scott Bessent to influence long-term rates by buying Treasuries, the market remains resilient. Long-term rates are primarily guided by short-term rates and economic conditions. The current modest spreads between short-term and long-term yields suggest a slowing economy but do not indicate concern over excessive government debt. Overall, the bond market's return to normalcy is a positive development, even though some may find the higher rates challenging.