10-yr Treasury yield update

As 10-yr Treasury yields work their way slowly higher (first chart), I thought it would be appropriate to revisit the long-term context (second chart). Yields are up almost 200 bps from their lows, but they are still very low by historical standards. To think that yields of 4% or even 5% pose a threat to the economy seems rather farfetched, when you consider that the economy grew strongly in the 1980s despite yields of 8% and higher, and despite yields being significantly higher than inflation. Similarly, it's hard to see how the recent emergence of trillion-and-a-half dollar deficits has had any meaningful upward impact on yields.

Yields are primarily driven by inflation, as the third chart shows. Secondarily, yields are driven by growth expectations, since this in turn suggests the direction and level of rates that the Fed seeks to target via the Fed funds rate. For now, yields remain historically low because the market believes that inflation is going to be low for many years (witness TIPS breakeven spreads of 2-2.5%), and the economy is going to be stuck in a "new normal" rut, with growth of 2-2.5% per year and a huge amount of economic "slack." That in turn suggests that the Fed is going to keep short-term interest rates very low for a considerable period (witness Fed funds futures and eurodollar futures which are priced to a 1% funds rate one year from now, and a 2.25% funds rate two years from now).

Yields will move higher if these critical assumptions about inflation, growth, and Fed policy are challenged. For example, yields are likely to move higher if economic growth proves stronger than expected, even though stronger growth would reduce the deficit.