Challenge

Imagine a scenario unlike any seen in the US since the 1980s.

The US 10-year Treasury reaches double-digit yields. Volatility spikes and investors flee Treasuries and corporate bond markets, seeking safe havens in equities and foreign bonds. The housing market screeches to a halt.

Could it happen?

A recent PGIM survey found that double-digit 10-Year Treasury yields—a low-probability event with outsized potential to derail markets—are a top tail risk for institutional investors in the US.

Darrell Duffie, Senior Fellow at the Stanford Institute for Economy Policy Research, notes that while not without precedent, double-digit Treasury yields are exceptionally unlikely.

“It would have to be some cataclysmic event,” Duffie says. “Something very extreme in Congress, or some very drastic loss of confidence in the US’ ability to pay its debt or control inflation.”

But today, when Treasuries are headed for their biggest annual loss in the 50-year history of the Bloomberg Treasury Total Return Index, and March 2020’s sudden crisis of confidence in the Treasury market still stings, there’s value in envisioning how ongoing yield rises might shape the economic landscape.

Impact

The ripple effects of double-digit Treasury yields could flow in any number of directions, depending on the root cause.

“How you get to those very high yields matters a lot for the rest of the world,” explains Duffie.

If inflation is to blame, then real assets will also likely reprice. If the underlying problem is a loss of confidence in the government’s ability to pay its debts, equities will suffer, as the force threatening the government’s fiscal capabilities is also likely to be battering the economy.

The pervasiveness of the issue is also a key driver of outcomes. A US-centric crisis would unfold very differently than a global one.

“If there was a loss of confidence in the US economy and therefore the ability of the Treasury to pay down the debt, then people would continue to own Treasuries in large quantities, but they’ll diversify more than they are now,” says Duffie. “For their safe-haven stores of value, they’ll move to European bonds.”

Investors would move en masse to bunds—German government bonds—but there aren’t enough to withstand the surge; yields on bunds would bottom out, and investors would set their sights on OATs—French government bonds. The cycle could continue, tapping Canada, New Zealand, Norway—all the safe government bonds that have relatively stable currencies.

But if the issue wasn’t contained to the US, many investors would move into gold, seeing it as a safe haven.

“Precious metals, art, real estate, anything that is a store of value in a world of great uncertainty—people will move into those asset classes,” Duffie predicts.

Roughly half of US Treasuries are held by foreign investors, primarily central banks and sovereign wealth funds, and countries that use Treasuries as a safe haven in their foreign exchange reserves would feel the strain. Japan and China, for instance, each own around a trillion dollars’ worth of US Treasuries.

This scenario would not only reflect major challenges in the global economy, but also further upend markets around the world.

Takeaway

Duffie is confident that the Fed’s interventions today will stop inflation from taking off to the degree that it did in the 1970s and ‘80s, and that 10-year Treasury yields will stop their climb at 5%, avoiding the double-digit scenario. Still, investor confidence remains a challenge. 

“There’s inflation uncertainty, there’s geopolitical uncertainty, there’s supply chain risk and there’s a lot of monetary policy uncertainty,” he says. 

All of that uncertainty risks kicking off a domino effect: Volatility goes up, balance sheets lose liquidity, investors shy away from the elevated risk and market quality deteriorates.

“People that work in the world of bonds are always thinking: What could be the next disaster?” says Duffie. “There are lots of potential disasters coming, and US deficits are now around their record high. That means we’re a lot more vulnerable now to major macroeconomic shocks. We need to get our markets in order, because we don’t know where the disasters are coming from.”

For Duffie, the structural changes the Fed is making in response to 2020’s liquidity crunch are vital to boosting investor confidence. 

“All roads lead to Rome,” he says. “All major economic problems that would upset the Treasury market are going to lead to the operation of the market. Why not make it what it’s said to be: the deepest, most liquid market in the world on a permanent basis, rather than most of the time.”