Who's afraid of 3%?

The all-important 10-yr Treasury yield rose above 3% today, and that naturally leads to all sorts of questions. Is it good, or is it threatening? Is the Fed too tight? Is inflation about to rise? Is the stock market at risk? I argue here that on balance it's a good thing, and the only ones who need to worry are those that are betting against the US economy.

Chart #1

Three years ago I predicted that we were in the early stages of a bond bear market, and Chart #1 is one validation of that claim: the multi-year downtrend in yields has been broken. To be honest, however, I was a bit early in my prediction. The bear market didn't start until 10-yr Treasury yields hit an all-time closing low of 1.36% in July '16. Today, 10-yr Treasury yields are trading with a 3-handle for the first time in almost seven years (with the exception of one day, Dec. 31, 2013, when yields reached briefly exceeded 3%). 

Chart #2

Chart #2 shows the history of 10-yr Treasury yields going back to 1925. The great bond bull market began when 10-yr yields hit an all-time high of almost 16% in September '81, and it lasted almost 35 years. Perhaps not coincidentally, my career as an economist began in early 1981 when I went to work for Claremont Economics Institute (CEI). That was just before CEI found itself in the limelight, the result of having produced the Reagan Administration's "rosy scenario" forecast that bond yields and inflation were going to plunge as the economy picked up speed. It took a few years before our forecast was vindicated, though none of us at the time would have predicted that bond yields would be falling for the next three and a half decades. What a ride!

Chart #3

Chart #4

As I see it, the first leg of the great bond bull market that has now ended was driven mainly by lower inflation, whereas the second leg was a function of slower real growth, coupled with fears that very slow growth would lead to very low inflation. Chart #3 shows how it took almost 20 years—from the early 1980s through the early 2000s—for 10-yr yields to close the gap between interest rates and inflation; as a result, real (ex-post) yields fell from very high levels to long-term average levels (1%-2%). As Chart #4 shows, the very low real yields of the past 7-8 years have tended to track the very slow real GDP growth of the current economic expansion. And very low real yields combined with low inflation expectations gave us very low nominal yields up until a few years ago.

Chart #5

Since 1997, when TIPS were first introduced, we have enjoyed daily, market-based measures of forward-looking inflation expectations, and that's better than comparing today's interest rates to last year's inflation. Chart #5 shows the history of nominal yields on 10-yr Treasuries, real yields on 10-yr TIPS, and the difference between the two, which is the market's expectation for what the CPI is going to average over the next 10 years. It's worth noting that the real yield on 10-yr TIPS today is just over 0.8%, whereas the ex-post real yield on 10-yr Treasuries (subtracting the year over year change in the core CPI) is also just over 0.8%. If anything, this suggests the market is confident that the future will be similar to the past, and that the Fed is on a sustainable path to raise short-term rates in line with improving economic fundamentals. 

Chart #6

If anyone should fear 10-yr Treasuries breaking through the 3% barrier, it's prospective homebuyers. Since 30-yr mortgage rates tend to trade about 1½ points above the yield on 10-yr Treasuries, the rise in 10-yr Treasury yields has produced a commensurate rise in mortgage rates, as Chart #6 shows. 30-yr fixed, conventional mortgage rates have been 4.5% or less for the past six years, but now they are moving higher. This is certainly bad news for homebuyers, but is it a bad thing for the economy?

Chart #7

To date, rising mortgage rates have yet to put a dent in the demand for new mortgages. In fact, as Chart #7 shows, new issuance of mortgages (for purchases, not refis) has risen significantly in recent years despite rising mortgage rates. This should not be surprising, actually, since it is rising demand for loans and a stronger economy which are bidding up the cost of borrowed money. The higher rates of the past year or two are not bad for growth because they are the natural result of stronger growth. Higher rates are only bad when they rise in real terms as a result of tighter monetary policy, but that's not the case today.

Chart #8

Chart #9

Chart #8 compares 2-yr US yields with 2-yr German yields. As Chart #9 shows, US yields have soared relative to their German counterparts, with the spread (blue line) now exceeding 300 bps. And it's not just nominal yields that have diverged: German real yields on 5-yr inflation-indexed bonds are -1.4%, far lower than today's 0.73% real yield on US 5-yr TIPS. Very low real yields in Europe are symptomatic of very weak growth fundamentals. That can be seen in the fact that the US stock market has vastly outperformed the Eurozone stock market since 2009, as shown in Chart #10.

Chart #10

Traditionally, as Chart #9 also shows, a wider spread between US and German yields has corresponded to a stronger dollar (shown here as a weaker Euro), because higher US rates usually reflect a stronger US economy. But since the beginning of the Trump presidency, this has not been the case: in fact, the dollar has weakened despite stronger US growth and higher US interest rates. It's mighty tempting to conclude that whereas Trump's policies have contributed to a strengthening of US economic fundamentals, global investors have steadfastly refused to join the party, perhaps because they can't stand Trump the man.

Chart #11

In similar fashion, as Chart #11 shows, since the beginning of 2017 gold prices have risen even as real yields have risen (and TIPS prices have fallen), contrary to the relationship that prevailed prior to 2017, when gold prices tended to track TIPS prices. The message here? The dollar seems awfully weak and gold seems awfully strong given strong US economic fundamentals. 

Dollar bears and gold bulls are the ones who really need to fear the advent of higher US interest rates. Arguably, they have misinterpreted rising US rates (and Trump) to mean bad news for the economy, when in fact they are good news. 

I'd wager that Larry Kudlow will be cheering the return of King Dollar before too long, and that would be a very good thing.