The biggest news of last week was not a tweet, but a Treasury yield – specifically the 10-year U.S. Treasury yield, which rose significantly last week, to 2.95%.1 As of this writing on Monday, the 10-year Treasury was yielding 2.98%, very close to the key 3% level it has not seen in more than four years.1 But what is this key market indicator telling us? And why do people care?
Let’s start with the second question first; people care for a number of important reasons.
- First of all, the 10-year U.S. Treasury yield is viewed as a more reliable indicator of sentiment than the stock market; more specifically, it is considered to be an accurate “fear gauge.” That’s because U.S. government bonds are viewed as one of the safest “safe haven” investments.
- Also, quite importantly, the 10-year yield is seen as an indicator of expectations about future growth and inflation.
- In addition, the 10-year yield is an important part of the yield curve; when the yield curve inverts from its normal slope, because rates on the longer end are lower than rates on the shorter end, it is viewed as a signal that recession may be coming.
- The 10-year Treasury yield is important for practical reasons as well; it is closely correlated with mortgage rates.
What is the 10-year Treasury yield telling us today?
And so, to answer the first question, I believe the 10-year yield is telling us several different things.
Growth. First of all, it is telling us the economic growth picture is solid. That makes sense, as the International Monetary Fund (IMF) just released its most recent World Economic Outlook, which shows an upward revision to the 2018 growth forecast for advanced economies (with no revision to the growth forecast for emerging economies) and a smaller upward revision to the 2019 growth forecast for emerging economies (with no revision to the growth forecast for developed economies).
Of course, that begs the question: If the IMF’s outlook for economic growth from emerging economies, especially China, is still expected to be strong in 2018, then why did China announce a 100-basis-point cut in the reserve requirement ratio for most of its banks last week? I believe the dramatic rate cut, which lowers financing costs for banks, is not a cause for great concern. It reflects a change in the People’s Bank of China’s macro policies rather than any kind of dramatic concern about the Chinese economy.
Inflation. From my perspective, I think the recent rise in the 10-year yield is telling us more about inflation than growth – specifically, that inflation is moving higher. In fact, we heard it from Federal Reserve Bank of San Francisco President John Williams, who last week explained that he expects inflation in the U.S. to reach the Federal Reserve’s 2% goal this year and stay at or above that goal for “another couple of years.” Many strategists believe the rise in the 10-year yield is due to the recent increase in oil prices. However, I believe several different factors – including tariffs and a tighter labour market, which can lead to higher wage growth – are the forces likely to conspire to increase inflation sustainably.
Market fears. So the yield on the 10-year Treasury indicates that growth may be solid this year and inflation could move higher – but presumably will not get out of control. It also tells us that market fears may be contained, as investors are not buying up “safe haven” U.S. Treasuries, which would send yields lower (coinciding with progress in lowering the tensions between the U.S. and North Korea).
However, we have seen significant volatility and abrupt changes in the 10-year yield before, so we need to stay alert for signs of clouds forming – especially since the IMF recently released its Global Financial Stability Report, which indicates that downside risks to global financial stability have increased “somewhat” since its report last October. Some of the key risks specified by the IMF include “financial vulnerabilities” resulting from years of extremely low rates, as well as “stretched” valuations of risky assets that could face a swift repricing.
In addition, we are seeing other risks, from protectionism to the potential that Brexit gets a lot messier. Last week the House of Lords rejected U.K. Prime Minister Theresa May’s Brexit plan that includes the U.K. leaving the European Union’s customs union. If the House of Commons also rejects that plan, we could see a challenge to her leadership, which could complicate the Brexit process with fewer than 12 months to go before the U.K. is slated to exit the European Union.
Supply and demand of government bonds. I also believe it’s worth noting that the yield on the 10-year U.S. Treasury can reflect expectations about supply and demand for U.S. government bonds. Recently the U.S. Congressional Budget Office released revised projections that show an expected increase in government deficits, which means the U.S. government will most likely be issuing more government bonds. In addition, as part of its balance sheet normalization plan, the Fed is gradually increasing the sales of U.S. Treasuries that it holds on its balance sheet. This all suggests there is a good possibility that, even if demand remains stable, supply will increase significantly – leading to falling Treasury bond prices and rising yields.
Yield curve. Finally, the 10-year yield is important because of the role it plays on the long end of the yield curve. There have been jitters in recent months because the yield curve has flattened, increasing the risk that it becomes inverted, which has historically been an indicator of an economic recession. In particular, the spread between two- and 10-year U.S. Treasury yields is very narrow, although it has increased slightly in recent days with the rise in the 10-year yield. Recall that the yield curve inverted in 2006, and a global recession followed soon thereafter. Ironically, this was despite then-Fed Chair Ben Bernanke’s attempts to offer benign explanations for this phenomenon in his speech, “Reflections on the Yield Curve and Monetary Policy.”
Last week, Williams, who will soon take the helm at the New York Fed, showed greater concern about what the yield curve signals, admitting that an inverted yield curve is a “powerful signal of recessions” because it signals that markets have lost confidence in the economic outlook. However, he believes the yield curve won’t invert any time soon, suggesting that the flattening of the yield curve we have seen thus far is a normal part of the rate hike process.
But no matter how robust economic growth is, there is always inherent fragility. So we will want to be vigilant in looking for signs that economic growth is peaking. For example, one area of focus for me is the German economy. Germany’s Macroeconomic Policy Institute recently announced that its proprietary economic indicator, the ZEW Economic Sentiment survey, implied a sharp increase in the risk of recession in Germany. Now the risk of recession is still relatively low, but such a large increase in just one month warrants more attention. That’s especially so given that the April ZEW survey showed a drop in expectations for the German economy to its weakest level in more than five years.
Risk assets. Finally, such a significant rise in the 10-year U.S. Treasury yield in just a few weeks suggests there could be some re-rating of risk assets, just as the IMF warned. We have already experienced this phenomenon in the last few months – recall the drop in stocks in early February when the 10-year yield rose materially – and so we will want to follow this situation closely. With regard to risk assets, I believe investors should consider maintaining exposure, but also be well-diversified and discerning in this environment.