Wednesday, April 25, 2018

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.


Andrew said...

Isn't the strength (or weakness) of the dollar primarily tied to the foreign investors appetite for US Debt?

We've significantly cut taxes. So, near term will need to finance Gov't operations thru issuance of more debt than otherwise. It will take some time for the US economy to improve enough so that overall tax collections rise.

Benjamin Cole said...

As always, great post and I love the numbered charts.

One question has been nagging me for a while.

If we have globalized credit and bond markets, why do Japan and Germany consistently offer lower real government bond yields than the US?

If someone offers to sell you a German bond offering negative real interest or a U.S. Treasury at 3% which do you buy?

Scott Grannis said...

Andrew: I have never found any correlation between US debt, interest rates and/or the dollar. It’s tough, for that matter, to find any durable relationship or factor that explains the ups and downs of the dollar. The FX markets are notoriously for their unpredictability. Nevertheless, I think it’s just common sense that the dollar ought to rise if real rates here are higher than real rates overseas, as they are now. Psychology sometimes gets in the way of economic and financial fundamentals, and that may explain the dollar’s lack of strength in the past 16 months.

I will post a chart at some point which shows that the only apparent relationship between US debt (the burden of debt) and interest rates is one that is very counter-intuitive: interest rates tend to rise when the burden of debt declines. Stay tuned.

Scott Grannis said...

Benjamin: international finance theory explains the conundrum you observe. In theory, countries with low interest rates are expected to have lower inflation than countries with high interest rates. Thus, the currencies of low interest rate countries should tend to appreciate over time, and the currrencies of high interest rate countries should tend to depreciate. An investor cannot therefore expect to make a greater total return investing in high interest rate currencies than he could by investing in low interest rate currencies. Low interest rates are boosted by an expected rise in the currency’s value.

However, the key to making money in the forex markets is to determine when the market’s expectations are unlikely to be met. I also think that the market has been wrong to ignore the higher and rising real rates in the US. Real rates are rising because real growth is improving, and thus investing in dollar assets ought to prove more rewarding over time than it has been of late.

BDunn said...

Ben, your question reminded me of an interesting J.P Morgan interview by Market Strategist, Dan Morris, of Economist, Yoshi Sakakibara, back in 2011 entitled ‘Japan's Debt Trap: Who's in the Trap?’.
Relevant excerpts: “Even though JGB yields are very low, that is only in nominal terms. Real yields are actually high and reasonable— precisely because of deflation in the economy. That is, there is almost no inflation risk currently priced in JGBs. That's why the term “fiscal premium” should not be applied to JGBs. Look at the comparison of real bond yields across the G3. They are about the same for all three countries.

...”At these low nominal yield levels, holding onto JGBs is a risky investment for outsiders whose returns are deflated by their own home inflation, and are also faced with exchange rate risks, without much cushion from coupons and roll-down effects. That's why JGB holdings by non-Japanese are so limited.”

At least for Japan, this put their paltry nominal yields in perspective.

Benjamin Cole said...

Bill and Scott: Thanks for your thoughtful replies.

I guess this is what I getting at---

Let's assume all three nations, US, Germany and Japan offer no risk of credit default.

Germany still puzzles me. You buy German bonds, not in marks but Euros.

You are saying when you buy a German bond, "I am willing to accept low interest rates, as I expect the Euro to appreciate relative to the dollar, or for Euro inflation to remain lower than the US."

The German 10-year sovereigns offer 0.62% (vs zero in Japan and 3% in the US).

(BTW, Bloomberg says German 10-year bonds have returned 44.03% YTD. Wow!)

Okay, fine, but the ECB is running a very aggressive QE program and holding rates low as we speak.

"The ECB’s benchmark main refinancing rate is zero, with policymakers also imposing a negative interest rate of minus 0.4 per cent on a portion of lenders’ deposits held at central banks."

Inflation in Europe is running at 1.3%.

When you buy a German 10-year bond you are getting a return at half the rate of Euro inflation. Negative real interest.


Japan makes some sense, but still. The Bank of Japan has bought back one-half of the nation's gigantic pile of debt, is sticking hard and heavy with QE, also has negative interest on reserves and the government pays zero on 10-year bonds.

Why would buy a 10-year bond that pays zero, unless you expect the yen to appreciate against the dollar, or deflation in Japan? They are running at about 1% inflation.

So to the Fed: You get 3% on a 10-year Treasury, the Fed pays 1.75% interest on reserves, and the Fed is doing reverse QE.

The upshot: People expect more inflation in the US than Europe and Japan, or the dollar to depreciate against the yen and Euro?

Why would the dollar depreciate against the yen and the Euro, given what the Bank of Japan and the ECB are doing?

Scott Grannis said...

Benjamin: the market may be crazy, as you suggest. But it's impossible to arbitrage the current situation. If you buy a short-term German bund and hedge out the currency risk with the dollar, you will end up with the same interest rate as if you had bought a similar US bond. The forward currency markets are priced to the interest rate differentials between currencies. If you think the market is crazy, you should sell German bonds and buy US bonds without hedging the currency risk, then see what happens.

marcusbalbus said...

your charts are like quixote's windmills.

Benjamin Cole said...


My take is markets are never crazy. I go with EMH. As you know, the number of investors who beat the market is like the number of nice guys in ISIS.

I just can't figure the reasoning.

I suspect there are some sort of structural impediments at play, but I don't know what.

John Cochrane sometimes talks about zero interest rates, and then bonds become the same as cash etc. It is an interesting topic. If the Fed-US can drive interest rates down to zero, then the cost of carrying the national debt evaporates.

People already carry huge amounts of cash in Japan and US. Interest-free loans to government, and growing rapidly. As you know the Fed cannot reduce its balance sheet that much going forward, as there will be so much cash in circulation.

Maybe they are there already in Japan. People pay money to have a bank account, or receive nothing for owning a 10-year JGB.

Scott Grannis said...

Benjamin: It may surprise you to know that the growth of cash in circulation has slowed a bit, but it cannot grow by enough to use up the $2 trillion of excess reserves anytime soon. There’s about $1.5 trillion of currency out there. It would have to more than double to use up the excess reserves. It’s only growing about 6-7% per year.

Every country can have its own interest rates. When there are differences between countries, the forward currency markets absorb/adjust for the differences. You can invest in high interest rate currencies and not hedge the currency exposure if you want, but you are exposed to forex risk in that case.

Benjamin Cole said...


Right, cash in circulation is growing at about 7% a year. But as you know from the rule of 72...

ckhajavi said...

Scott - I am perplexed by how reticent the equity market is to price in stronger growth - even causal diners who have secular issues are putting up amazingly strong comp store sales despite horrific weather - I’ve studied the us consumer for a long time and they are acting very confident / starting to spend more freely - I think the market is concerned we have added so much temporary stimulus in the form of tax cuts / accelerated depreciation that we are just pulling forward the next recession - I would argue there is still a lot of slack in the economy and we are not as late cycle as everyone fears - I would love your view on this? I’m also a firm believer that technology is a deflationary force now - we will be producing seasonal foods all year with new tech / driving down healthcare costs with ai / making manufacturing cheaper with 3D printing etc - if I’m right that should keep a lid on inflation and hence higher growth is unlikely to drive a massive uptick in prices - maybe I’m too optimistic but this would equal Goldilocks with low inflation and healthy growth - curious if you are a believer in this theory - thanks again for your blog - it’s always a pleasure to read your thoughts

Scott Grannis said...

Cameron: I too am amazed at how reluctant the market is to price in stronger growth. But bear in mind that "reluctance" has been one hallmark of this recovery. In fact I gave a presentation back in October 2012 with the title "The Reluctant Recovery." Read about it here:

I do believe there is "slack" in the economy, and I think Chart #3 in this post speaks directly to that.

I do not believe that technology is responsible for keeping inflation low, and I do not think inflation comes from the labor market. Inflation is a monetary phenomenon that is entirely under the control of the Fed. Technology can appear to limit inflation, but only because it expands the economic pie (via higher productivity). If the Fed makes no change to the supply of money but the economy expands, then that equates to a relative "tightening" of monetary policy. Lots of growth could be deflationary if the Fed didn't take offsetting steps to expand the money supply.

Rob said...

Thanks Scott. Any thoughts on what this means for Cable (£-$ rate) ? Is £ currently overvalued ?

Scott Grannis said...

By my PPP measure, both sterling and the Euro currently are modestly overvalued (5-10%) vis a vis the $. So if the $ strengthens, I see little reason why it couldn't rise vis a vis sterling.

Rob said...

Thanks Scott.

ckhajavi said...

Dollar starting to strengthen now Scott - also yields moving up - Atlanta gdp now at 4.3 percent although will get revised down - maybe market starting to come around

ckhajavi said...

Equities seeing something most other asset classes aren’t - odd