There is constant speculation about the direction of US Treasury bond yields, particularly the 10-year. This is because US Treasuries are the global low-risk asset, ‘par excellence’. 
Liquidity, widespread ownership and benchmark status mean Treasuries both influence – and are influenced by – global financial markets.
Recently, the rise in yields of Treasury bonds has contributed to higher volatility in other bond markets and asset classes around the world. Investors are concerned about how much further Treasury yields will rise.
However, what is often missing from the equation is discussion about the fair value of Treasuries at a given point in time. Having an informed view on what a bond’s value ‘should’ be is an important guide to decision making – especially if fair value is out of line with current market pricing.
Fair value of Treasuries can be estimated using a number of different approaches. One is to use fundamental economic data to generate the expected probability of a US recession in the coming years. This information is used to identify the likely path of short-term interest rates over the same period, to then calculate the fair value of Treasuries today. For example, by the third week of March after the US Federal Reserve meeting, this method was outputting a fair value of between 2.85 per cent and 3 per cent for the 10-year US Treasury. Yields for the 10-year Treasury were at 2.85 per cent.
Another method to estimate fair value is to compare what the Fed is likely to do over the next few years – as outlined in the Federal Open Market Committee (FOMC) member projections for the Federal Funds rate – with the 30-year Treasury yield. Over the past 25 years, 30-year Treasuries have been good at finding the peak of the Fed funds rate and 10-year yields in rising interest-rate cycles.
By the third week of March, the Fed dot plot – which shows the interest-rate projections of the 16 FOMC members over various calendar years – was predicting Fed funds would peak between 3.25 per cent and 3.5 per cent, while the 30-year Treasury yielded about 3.15 per cent.
A third element to look at is the breakdown of nominal yields into inflation breakevens – the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity – and the real yield. After remaining below the Fed’s 2 per cent inflation target for several years, 10-year inflation breakevens have recently pushed back above this mark, suggesting it is now fair value. Real yields have also risen, but a 10-year yield at roughly 0.8 per cent as of 22 March still appears slightly low compared with long-term potential GDP growth.
These and other methods can be combined to estimate a range of longer-term fair values of Treasuries of different maturities. This can give investors a good indication of what an investment approach to Treasuries and other fixed income sectors should be.
The measures above imply, while 30-year Treasury yields were within fair value range, 10-year yields were slightly below fair value – in other words, the 10-year were overpriced. This information would also keep us slightly cautious on sectors more sensitive to Treasury yields, such as investment grade credit.
Ken Orchard, co-portfolio manager of the T. Rowe Price Diversified Income Bond fund. The views expressed above are his own and should not be taken as investment advice.