Estimate of the “fair value” of the 10-year US Treasury yield: July 12, 2024

The spread between the yield on 10-year US Treasury notes and a fair value estimate calculated by CapitalSpectator.com narrowed to a three-month low in June. The market-based yield is still well above this fair value estimate, but as expected in recent months (see here, (for example) a decline in the excessive market premium is still expected.

Yesterday’s sharp drop in the 10-year yield suggests that the downward pressure from the fair value estimate on the market rate remains intact. Following Thursday’s news that the 1-year trend in U.S. consumer inflation fell to 3.0% in June, the lowest level in more than three years, the 10-year rate fell to 4.22%, the lowest since late March.

A fed funds model I developed for TMC Research suggests that the central bank’s optimal target rate should be about 50 basis points lower than the current target rate of 5.25%-5.50%. Fund futures are pricing in a greater than 90% probability that the Fed will begin cutting rates at the September 18 FOMC meeting (no change is expected at the July 31 meeting). Meanwhile, the 2-year policy yield fell sharply yesterday, falling to 4.52%, the lowest level since early March.

The most important finding: Market pressure in favor of lower yields is increasing. The expected narrowing of the spread between the 10-year yield and the Capital Spectator fair value estimate is likely to occur in the near future.

The current three-model average fair value estimate for June is 3.40%, in line with the most recent monthly estimates. This estimate is 91 basis points below the actual 10-year yield last month.

The difference between the average fair value and the market rate continues to reflect a significant premium. The current difference is high, but recent data shows that the spread has peaked and will continue to narrow in the coming months, or at least that is what history suggests. Although there are periods when the market premium increases, these events are usually relatively short and are followed by periods of normalization, as shown in the chart below.

There is no guarantee that history will repeat itself and the range will narrow, but a number of factors suggest that this is a reasonable forecast. In particular, there are signs that US economic growth is slowing – a key indicator that, if true, will likely push the 10-year yield lower in the coming weeks and months.

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Editor’s note: The summary points for this article were selected by the editors of Seeking Alpha.