JOHN MASON - The picture evolving from rising bond yields
The picture evolving from rising bond yields
The yield on the 10-year US Treasury note closed today at 3.17 percent. This is the highest the yield has closed at since July 2011.
Many, myself included, have been waiting for this yield to break through the 3.00 percent level and then go on to higher levels since last December. For many reasons, maintaining this yield below this level seemed unreasonable given the state of the economy and the place the United States found itself in the economic cycle.
The Federal Reserve has raised its policy rate of interest eight times since it started increased the rate in December 2015.
The short-term rate, therefore, was rising, and the longer-term rate of interest was not rising in tandem. Consequently, over the past nine months or so, concern has been rising that the term structure of interest rates was flattening out and the fear in the investment community rose that some time soon…especially given the length of the current economic recovery…the term structure curve might invert, which would be a pretty significant signal that the economy might be heading into a recession.
Martin Feldstein, Harvard economist and former chair of the President’s Economic Council, has been talking up a pending recession, perhaps one rivaling the Great Depression.
With the Federal Reserve signaling that it will raise its policy rate one more time this year, in December, followed by three more increases in 2019, it really appeared possible that the term structure would invert sometime in the next three- to six-months, if the yield on the longer-term interest rates failed to rise.
Today, the apparent ceiling to the yield on the 10-year Treasury note crumbled. What does this mean?
Well, the early analysis to the change attributes the rise to new data coming out today indicating that the economy is perhaps stronger than analysts had been predicting. These data point to stronger consumer spending, rising wages in a relatively tight labor markets, and increasing prices.
So, let’s look at the composition of the yield, dividing the yield into two components the expected real rate of interest and the expected rate of inflation. Both show substantial changes.
Looking at inflationary expectations, we see that at market close, expected inflation was just under 2.20 percent at the close.
Most of the year, inflationary expectations have been around 2.10 percent, although there had been some signs that this measure was increased in recent weeks, given the statistics that was being released by the government.
Perhaps the most important change has come in the expected real rate of interest, proxied by TIPs closed at 98 basis points, almost 1.00 percent. This is the highest that this yield has been for seven years. In July of this year, the yield was below 80 basis points.
This latter movement is the most important change for me because economists believe that this expected real rate of interest is the market’s estimate of what future real economic growth is going to be. Therefore, if the economy is growing stronger, the return on the TIPs should be rising along with the growth rate.
With the real rate of growth of the United States economy, year-over-year, around 2.8 percent, calculated historical relationships indicate that the yield on the 10-year TIPs should be above 2.0 percent.
Thus, even with the yield getting around 1.00 percent, the expected real rate of interest should be at least double where it is today. This is one of the reasons that many of us have been looking for an eventual rise in longer-term US rates.
And, if this argument is correct, the concern over the inversion of the term structure of interest rates falls into the background. One could then assume that a recession is not right around the corner as some have been expecting.
Furthermore, If we are not near the end of the current economic recovery, the Federal Reserve will still have further justification for raising its policy rate of interest throughout 2019.
Right now, even with the eight increases the Fed has made in its policy rate of interest, and with the year’s effort to reduce the size of its securities portfolio, my analysis has indicated that Federal Reserve monetary policy is not really restrictive. Therefore, what the Fed is doing is attempting to “normalize” US financial conditions.
If this is so, then monetary policy is not holding back the rate of growth of the economy, and, for the near term, future increases in its policy rate along with a continuation in the reduction of the Fed’s securities portfolio will not hold back the rate of growth of the economy.
And, the Fed’s actions, over the next year or so, will not stop the rise in the rate of inflation.
If all of this is true, it means that the United States is moving farther out-of-line with Europe and the European economies. In a real sense the United States seems to be getting stronger, while Europe seems to be falling further behind.
Where is this showing up, and where will it continue to show up in the markets?
Look at the Euro/US dollar relationship. At the beginning of February 2018, it took more than 1.25 dollars to purchase one Euro.
At the close of business on Thursday, it took only $1.15 to buy a Euro.
Over the past eight months, the US dollar has gotten stronger and stronger against the Euro.
I the scenario I presented above works out with the Federal Reserve continuing to raise its policy rate four more times by the end of 2019 and with the yield on the longer-term Treasury securities rising up to maybe 3.50 percent or more, the US dollar will continue to strengthen against the Euro.
In spite of President Trump’s desire to produce a “weak” US dollar to support US exports and close or eliminate the foreign trade deficit in the US, the dollar seems to be getting stronger against the Euro…and, for that matter, against most other currencies.
This seems to be the picture evolving from the rise of bond yields in the United States.
In reality, these results continue to point to the bifurcation that is being experienced between the US economy and the economies of the European Union. This is something I believe that the leaders of the EU in Brussels are going to have to take into account as they move forward.
I don’t see this gap narrowing in the near future.