Wednesday, July 6, 2016

Who's afraid of 1.3%?

Investors today worry about the implications of the fact that 10-yr Treasury yields fell to a new all-time low of 1.32% this morning. Does it mean the Fed is too tight? Does it reflect a threat of deflation? Is the global economy on the verge of another recession? Are we on the cusp of a exploding debt bubble? Will we never seen real growth exceed 2-3%? Are yields going to zero? Will US yields follow German and Japanese yields into negative territory?

If history is any guide, there's reason to cheer, not despair.

The previous all-time low for 10-yr yields was 1.39%, recorded July 24, 2012. Investors who bought the 10-yr that day and still hold it have received a total return of about 5.7%. Investors who bought the S&P 500 that day and held on—shunning the widespread fears of global recession and deflation that plagued markets four years ago—received a total return of 54%. Gold and commodity prices fell some 15%.

This should not be construed as a recommendation to put your life savings in stocks. It's merely to point out that the future doesn't always turn out to be as bad as the market expects. Sometimes it turns out to be much, much better, as has been the case for the past four years.

My best guess as to why yields are so low? It's simply that the market is very worried, and about a lot of things: quantitative easing, negative yields overseas, slowing growth, geopolitical tensions, bad fiscal policies, deflation, etc. The market may be right to worry, but it may also be wrong. In order for an investment in 10-yr Treasuries today to beat alternative investments, an awful lot of bad things are going to have to happen over the next several years.


30-yr Treasury yields also hit a new all-time low today:

In order to reverse the decline in yields, we'll need to see more optimism regarding economic growth and/or clear signs of rising inflation. Stronger growth, in turn, will require a return of confidence that would follow expectations of improved fiscal policy (e.g., lower tax rates, reduced regulatory burdens). The House under Speaker Ryan is moving in the right direction with budget reforms, but those won't pass as long as Obama has his veto pen and fails to grasp what is really needed to get the economy moving. As for inflation, we've seen a gradual rise in core inflation at the consumer level (2.2% year over year, and 2.4% annualized over the past six months), but broad-based inflation remains below 2%.


Grechster said...

I would just point out that the real interest rate on the 10-year Treasury is even more compelling than your chart indicates... That is, with an official inflation rate of 1.3-2.0% per year (depending on your metric), the real yield is about zero or slightly negative. This has never happened, until now, in the history of American commerce. (Or has it? I think that last statement is correct; does anyone have info to the contrary?)

Scott Grannis said...

The 10-yr Treasury yield has been lower than the rate of inflation quite a few times in the past 55 years: first in the mid-70s, then in the late 70s and early 80s. Those episodes were dominated by high and rising inflation and relatively high yields. Real yields were also negative in 2008 and 2011, when inflation moved higher on the back of rising oil prices but yields were generally low and falling. Today, and relative to the Core CPI, real 10-yr yields are about -0.8%.

marcusbalbus said...

put all your money immediately in stocks. grannis said its ok. we demand more QE

Andrew said...


It is tempting to blame Obama for slow growth, but not satisfying.

Slow growth is common in other diverse counties.
Consider Germany, UK and Japan.

China has growth, but doubt many Americans would desire such a system.

Benjamin Cole said...

I suspect lower interest rates ahead.

The US Federal Reserve probably won't go back to QE. Rates have been falling under the current regime. The globe is awash with capital. Why should rates rise?

The lessons of Takahashi Korekiyo, Japanese central banker in the Great Depression, are worth pondering.

To be sure, less taxes and regulations. Eliminating property zoning would bring a building boom to the West Coast.

Scott Grannis said...

Andrew: Slow growth is indeed common in other countries, but I note that those countries share the same burden as the US: very high tax rates, very burdensome regulations, high levels of government spending relative to GDP, high levels of transfer payments. The US has become more European-like under Obama, and it shows. Japan is notorious for its high level of government spending and its miserably slow grow going on decades.

Ireland's low tax rates helped it achieve 9% growth last year. The other EU countries complain that Ireland is competing unfairly. Spain has restructured and liberalized its economy and not surprisingly grew 3.4% in the year ending March. Italy, in contrast, grew only 1%.

With Brexit, the UK expressed its frustration with the EU bureaucracy, and I'll wager it will enjoy faster growth in coming years.

Roy said...

"My best guess as to why yields are so low? It's simply that the market is very worried"

Looking at the charts there are obvious downward trends for DECADES now. So, that's because the market has been very worried for decades? Surely there is something more to it.

Scott Grannis said...

Until a few years ago, the decline in yields could easily be attributed to the decline in inflation. But now that yields are below the rate of inflation, I think there is something else at work.