Bond yields are on the rise | GETTY

Short term US Treasury yields reached their highest peak since July 2007 last week, after new official data revealed the US economy is still coming in hot. The ten-year Treasury yields, which many use as a benchmark for the economy, hit their highest level since December 30.

The latest increase has Wall Street worried about a potential recession – and the Fed more determined than ever that more interest rate increases are needed. Let’s take a look at what’s driving yields up and if inflation is here to stay.

US Treasury yields up to 2007 levels

The 10-year US Treasury yields were at a two-month high last week, hitting 3.86% before dropping slightly to 3.82% by Friday.

Other yields were doing the same: the two-year Treasury yield hit 4.6%, while one-year yields briefly hit 5%. The last time the latter hit those levels was July 2007.

High yields affect the price of bonds, which are considered to be the ultimate safe investment. They’ve been sensitive to the new data we’re seeing on the US economy’s health, which isn’t behaving as the Fed expected.

But what kind of data is driving Treasury yield rises?

What is causing yields to rise?

At the start of February, the Fed continued to pump the brakes on mammoth interest rate hikes that began in March 2022. The latest hike was only a quarter-point increase, a stark difference from the gargantuan strides made last year.

At the time, inflation was seen to be cooling off. It had declined seven months in a row, falling from a high of 9.1% in June last year to 6.5% by December. It looked like the worst was behind us.

However, more data has rocked the boat and sent a resounding warning that we’ve not yet seen the last interest rate rises.

The unemployment rates in the US are now at their lowest ebb in 53 years, hitting 3.4%. Job creation was much stronger than anticipated, with 517,000 new roles in January against a 185,000 prediction from analysts.

The January 2023 inflation result was the next data set to defy expectations, rising at a rate of 6.4% instead of the expected 6.2%. This meager fall, combined with the job news, sent alarm bells ringing across Wall Street.

It hasn’t gotten better since then. The producer price index, which tracks wholesale prices, rose to an annual rate of 6% against an expected decrease to a level of 5.4%.

Retail sales in the US rose by 3%, the highest increase in nearly two years and showing the public is still spending despite borrowing pressures. This is likely buoyed by the cost-of-living adjustment for 65m Social Security recipients across the US.

While this is all good short-term news on the avoiding-a-recession front, it makes the Fed’s job a lot more difficult when it comes to taming inflation in the long term – and pushes Treasury yields to do unusual things.

Why does it matter?

Treasury yields are kind of a big deal. They influence how much it costs the US Government to borrow money, how much interest bond investors will get and the interest rates everyone pays on loans.

And the 10-year Treasury yield? It’s the jewel in the crown. This is the one that’s used to measure mortgage rates and confidence in the market. If the yields are higher here, it could grind the housing market to even more of a halt.

Right now, we’re looking at an inverted yield curve. This happens when the shorter-term yields have higher returns than the long-term yields. An inverted curve has historically meant a recession is on the way, and that can be enough to scare off banks from lending.

The tight labor market is another headache for the Fed. At the moment it’s an employee’s market which is, in turn, driving up wage growth. As for Treasury yields, they’ve steadily risen since the news. The stronger-than-expected price indexes aren’t helping.

But further hikes in interest rates to try and calm everything down have a knock-on effect on short-term yields, risking widening that inverted curve even more – and then we could be in recession territory, depending on the data.

How are the markets reacting?

When Treasury yields go up, the stock market tends to do the opposite – and that’s exactly what happened last week.

The S&P 500 closed 0.3% down at the end of the week, having suffered its worst day in a month on Thursday. Adding to the doldrums, the Nasdaq Composite lost 0.6%.

If Treasury yields continue to rise, we’ll likely see further volatility in the stock market.

Is inflation here to stay?

There are a lot of different data points that feed into the health of the economy. But none of the data we’re seeing makes much sense when it comes to traditional economics – and inflation is sticking around for now.

A few short weeks ago, investors were pricing interest rate cuts by the end of the year. Now, the outlook is decidedly gloomier with a peak of up to 5.5% interest expected.

Fed officials are loud and clear about the direction of travel. Cleveland Fed President Loretta Mester said last week her expectation was “that we will see a meaningful improvement in inflation this year and further improvement over the following year, with inflation reaching our 2% goal in 2025”.

Meanwhile, St Louis Fed president James Bullard voiced that a half a percentage point rise in interest rates was on the table for the next meeting.

If that turns out to be the case, look out for the two-year Treasury yield which is highly sensitive to interest rate rises. From there, we may have a clearer path on where the economy is headed.

The bottom line

All eyes will be on the yield rates going forward to see if this is a one-off high or the beginning of something bigger. One thing for certain is that inflation is pretty stubborn right now, so we can expect the Fed to remain steadfast in its goal of raising interest rates to tame it.