The bond market begins to figure things out

For the past year the stock market has had a blast pricing in tax reform. The S&P 500 is now up some 25% or so since the day before the November '16 election, and that gain is only slightly more than the degree to which a cut in the corporate tax rate, from 35% to 21%, causes a one-time rise in after-tax corporate profits. (Here's the equation: (1-.21)/(1-.35) = 21.5%.) The bond market, however, hasn't taken much notice: 10-yr Treasury yields today are 2.45%, only modestly higher than the 2.33% they have averaged over the past year. On the other hand, 5-yr real yields on TIPS (a key, must-watch indicator as I've argued), today have climbed to 0.37%, which is meaningfully higher than the 0.05% they have averaged over the past year. The rise in bond yields is still modest, but the rise in real yields is better still, since it's the best indicator that the bond market is beginning to price in a stronger economy. And we're still in the early innings. Bond investors, hold on to your hats.

I first raised this issue—how the stock market was excited about tax reform, but the bond market was ignoring the likely consequences—in a post two weeks ago (Tax reform is priced in, but not a stronger economy). It now looks like the bond market is in the early stages of figuring out that a big cut in corporate tax rates is indeed likely to result in an investment boom and a stronger economy in the years to come. The ranks of the Trump despisers have been thinning ever since the summer of 2016, as more and more become convinced he is going to adopt more business- and growth-friendly policies, and the bond market is now beginning to join the party. Yields have just begun what could eventually prove to be a significant move higher, and early signs of that can be found in the slope of the yield curve, which has steepened in recent days.

 Chart #1

Chart #1 shows the slow and gradual uptrend of 5-yr real yields on TIPS. In the past 18 months they have risen by 85 bps, and 70+ bps of that rise has occurred since just before the November '16 election.

Chart #2

To be sure, one of the driving forces behind higher real yields is the Fed. Chart #2 shows how the Fed has raised real short-term rates by about 140 bps (from -1.4% just before the '16 elections to about zero now), by increasing its nominal overnight target rate by 1% during a period in which core inflation has fallen from 1.9% to 1.5%. The same chart also shows how the real yield curve has flattened during that same period, as 5-yr real yields (red line) rose by less than overnight real yields. That's again symptomatic of the bond market's reluctance to believe in a stronger economy. (The Fed has shared this belief, and still holds to it, but that is likely to change going forward.)

Chart #3

Chart #3 shows how real yields on 5-yr TIPS have a strong tendency to track the economy's underlying growth rate. As real growth picks up, real yields are very likely to follow suit. If the economy upshifts from 2% real growth to 3% real growth, as already seems not only possible but likely, real yields are likely to move to 1% or more. Nominal yields will likely rise by about the same amount, assuming inflation expectations remain relatively stable. If we end up with an investment-led boom that delivers 4% real growth, real yields could easily rise to 2-3%, pushing nominal yields on 10-yr Treasuries to 3.5-4.5% or so. Will that kill the economy? No, because higher yields and a stronger economy go hand in hand. We only need to worry about higher yields when the real and nominal yield curves go flat or invert, because that will be a sign that the Fed is too tight. That's not the case today, and the Fed is taking pains to emphasize that it won't move rates up aggressively.

Chart #4

Chart #4 shows the evolution of the yield curve from 2 to 10 years (the top panel shows 2- and 10-yr Treasury yields, the bottom panel shows the spread between the two). The curve has flattened substantially since early last July (a sign of the bond market's reluctance to embrace stronger growth), but it has steepened by 8 bps so far this week.

Keep an eye on real yields and the slope of the Treasury yield curve. They are excellent barometers of how optimistic the capital markets are about the prospects for stronger economic growth.

And don't worry about the impact of higher yields on the economy—at least not until you start to see the yield curve inverting.