The yield on 10-year Treasury bonds has dropped nearly 25 basis points to below 1.5%, touching 1.42% overnight on June 11 from its recent peak of 1.74% on March 31.
If the initial move up to 1.74% can be rationalized as a response to the risks around higher growth and inflation, then this recent move below 1.5% in the midst of an economic recovery involves a resetting of those concerns.
The factors in this down cycle likely include:
- Politics: Passing an infrastructure package becomes more difficult every day, making a multitrillion-dollar package less likely.
- Inflation expectations: Inflation is a feature of the initial post-pandemic recovery and not a significant risk as professional investors appear to be backing away from the inflation trade and the possibility of a return to 1970s-style inflation.
- Increased demand for bonds: There is recognition that Treasury bonds provide a risk-free return in an increasingly risky economic and national security environment.
- Productivity: Improvement in some of the sectors hit hardest by the pandemic, along with working from home, will most likely result in re-optimized working arrangements and a strong medium-term increase in productivity, lifting wages and living standards. (See “Why Working From Home Will Stick” from the National Bureau of Economic Research.)
Regardless, sub-2% interest rates by any degree are not what a healthy economy would support and suggest the need for sustained support from the fiscal and monetary authorities. An infrastructure package that increases productivity and competitiveness of the U.S. economy will pay for itself when interest rates are this low.
Changes in real yields
The increase in inflation to 5% in May from 4.2% in April has pushed the real (inflation-adjusted) yield on 10-year Treasury bonds even lower, to negative 3.5%. The goal of the monetary policy is to facilitate investments by pressuring interest rates lower. A negative real-yield curve and expectations for a growing economy and normal levels of inflation will allow those investments to be paid back in inflation-depreciated dollars.
Growth concerns, inflation risks and interest rates
Confidence in the recovery has nearly eliminated the perceived risk of economic collapse and deflation. At the same time, guidance from the Federal Reserve consistently calls for low-for-long money market rates.
If all goes to plan, the result will be an economy that can support higher long-term interest rates, while monetary policy pressures short-term bond yields lower. That would create a steep yield curve out to 10 years that would be conducive for bond trading as an alternative to riskier investments in other asset classes.
But there are never straight lines in asset pricing. A recent adjustment in the term premium priced into 10-year Treasury yields and the decline in expectations for short-term rates over the next 10 years both reflect a rethinking of the recovery’s trajectory.
Prices are increasing, which should be a welcome sign of increased demand and normal economic activity. Inflation expectations have been stable both during the pandemic and as the recovery has taken hold. That reflects both confidence that the monetary authorities will know how to handle inflation pressures should they arise, and the uncertainty regarding the fiscal response to the recession and the speed of the recovery.
Prices are increasing, which should be a welcome sign of increased demand and normal economic activity.
The Philadelphia Fed’s ATSIX estimate of inflation expectations for the next 10 years increased only slightly, to 2.3% in May from 2.1% last August. We regard the latest tick higher as a reaction to what economists consider to be transitory price increases because of pandemic production shortages and supply-chain bottlenecks.
The Fed has said that because inflation and demand have been abnormally low for so long, it will tolerate inflation rates greater than its 2% target before it undertakes rate hikes. We anticipate the inflation rate moving higher than 5% this summer until 2020 base-year effects, or the comparisons to the low levels of a year ago, are no longer a factor. And by the time children are back in school, the supply-chain issues will begin to work themselves out and consumers will begin turning to other available choices.
Our expectations are that 10-year yields will approach 2% before the end of the year as vaccinations continue for younger people and life gets back to normal. Even then, yields would still be below the trend decline in interest rates shown in the analysis below. A break above 2% would be a sign of a healthy and competitive economy and would go a long way to thwarting the development of bubbles in other asset classes.
When will the economy support higher interest rates?
Because of the structural shifts in the global economy—automation, the advent of the global supply chain, and the adaptation of inflation targeting by central banks—the expected return on investment has trended lower, particularly in the aftermath of the financial crisis and the Great Recession. The developed economies arguably can no longer support the high real (inflation-adjusted) rates of return in earlier decades.
We need to create the foundation for the next economy, both in physical terms and in intellectual terms.
According to an analysis by Kathryn Holston, Thomas Laubach and John C. Williams at the San Francisco Fed, the natural rate of interest is defined as “the real short-term interest rate that would prevail absent transitory disturbances.” According to another analysis, by Thomas A. Lubik and Christian Matthes at the Richmond Fed, the natural rate of interest is a hypothetical interest rate that is “consistent with economic and price stability.”
Holston, Laubach and Williams wrote that the natural rate provides a benchmark for monetary policy. Real short-term rates below the natural rate indicate an expansionary policy, while real short-term rates above the natural rate indicate a policy of contraction. As Lubik and Matthes wrote, “it is not the level of the natural rate that matters but its value relative to other interest rates.”
During the decade-long recovery from the Great Recession, U.S. real short-term interest rates have been negative and below the natural rates estimates for all but a few occasions. That indicates monetary policy has been accommodative, even during the period of interest-rate normalization near the end of the recent business cycle that drew so much criticism.
In our opinion, the decline in the natural rate of interest from the Great Recession and the concurrent secular decline in 10-year yields and gross domestic product growth—which we show in the figures below—suggest structural issues in the economy that we have yet to overcome. Despite the best efforts of the monetary authorities, the fiscal authorities need to do more if the United States is to avoid becoming the Japan of this century.
We need to create the foundation for the next economy, both in physical terms—through traditional structural improvements such as rethinking the energy and broadband grids—and in intellectual terms, by addressing the deficiencies in education and health of the labor force. The United States is no longer the leading exporter of the world. Simply rebuilding the old economy is shortsighted and a waste of resources.
In our estimation, an increase in the natural rate in the first quarter is a positive first step toward normalization of interest rates and offers the potential for a sufficient return on investment and the re-imagining of the U.S. economy.
The recovery, fueled by the confidence in the vaccination program, is evident in the spread between high-yield corporate bonds and Treasury bonds. A growing economy indicates diminished risk of corporate default, and a reduced premium required to hold those bonds.
The bid-to-cover ratio has remained comfortably above two, an indication of the demand for Treasury securities despite their lack of return relative to other, more risky assets.
Purchases of Treasury bonds by foreign investors continue to increase. We attribute this to increased commercial demand for parking profits (from trading with American importers) in U.S. securities, and the implied safe-haven demand of those purchases. Increased demand in any form will help keep a lid on increases in yields and will allow the Fed to think about reducing its purchases of long-term bonds.
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