I like to think I’m fairly experienced when it comes to financial commentary. I have been writing for this newspaper since 1990 and this column since 2006. In that time, I have witnessed a couple of bubbles, a couple of crashes and any number of financial crises. But I have no experience whatever of a bear market in Treasury bonds. Neither does anybody else much under the age of 60.
Bear this in mind as you digest the welter of coverage that we are devoting to what seems like a technical adjustment. The yield on the 10-year Treasury note is now 2.56 per cent. That is close to double the low of 1.36 per cent shortly after the Brexit referendum in 2016. But it is still an increase of not much more than a percentage point to a level that is not very high. Back when the bond bull market started amid the gloom and stagflation of 1981, the 10-year yield stood at almost 16 per cent.
So we should be clear that the recent rise in bond yields does not — yet — change anything much. The reason so many column inches have been devoted to the selling of bonds (which pushes up their yields) is that it might portend a change in conditions that is hugely significant, in which few of us will have any lessons from experience to guide us.
Bond yields have trended down since 1981 primarily because inflation, and the expectation of future inflation, have been squeezed out of the system. US inflation stood at 14 per cent in 1981 when the Federal Reserve under Paul Volcker declared war on it. Now, the Fed is trying to meet its target rate of 2 per cent, and finding that task hard. With inflation low, the fixed income and principal from your bond investment will not erode much over time, so it makes sense to pay more for it. As Treasury bonds are very safe — backed by the taxing and money-printing power of Uncle Sam — the 10-year yield is a benchmark for the entire financial system.
Low yields mean cheaper lending and borrowing rates. They justify a lower yield on stocks, and thus push up stocks’ price, while making life much harder for savers — particularly those running pension funds — as guaranteed future income gets more expensive.
Reversing all of this would change the terms of trade throughout the financial world. What many of us fear is that yields could rise very sharply once it is clear that they are in an upward trend. That could create domino reactions throughout the financial system. With the world economy in great shape at present, this is by far the greatest risk on the horizon.
But is it going to happen? Beyond inflation, there are technical reasons for lower rates. Central banks — notably in China and Japan — keep their currency reserves in US Treasury debt. They have been buying bonds as a deliberate way to keep yields down. Populations are ageing and need to buy more bonds. Government regulations force many institutions to buy more bonds.
But inflation is most important. Without it, bond yields will not rise far. And it is still only an assumption that inflation will rise. For now, it remains bottled. The latest year-over-year core inflation number for the US (excluding food and energy) is 1.8 per cent. Inflation expectations, derived from the bond market, point to an average inflation over the next decade of exactly 2 per cent.
The case to fear future inflation rests on the long recovery in the US labour market, which should raise the bargaining power of workers, and lead to higher wages. Meanwhile, surveys of employers show a big rise in new orders, which should mean greater demand and greater spending. On top of this, the US has just legislated a big tax cut. That should mean more money to spend, which should drive up spending.
It may work out that way. But here are reasons why the great turn in the bond market may be delayed further. First, the tax cut is largely going to companies, and not particularly to the poorer consumers who would have the strongest propensity to spend any extra money they received via the tax cut.
Second, the new industrial orders are for equipment that should help boost productivity and, as Joe Lavorgna of Natixis points out, the annualised growth in the price of non-residential equipment investment for the last five years is exactly zero. This industrial boom need not be inflationary.
As for jobs, the headline unemployment rate is low at 4.2 per cent but this does not include large numbers who are not even looking for work. According to Erik Hurst of Chicago Booth Business School, 18 per cent of men between 21 and 30 who did not have a college degree last year did no work at all. The equivalent figure for the worst year of the early 1980s recession was 6 per cent. This large potential workforce, which may be occupying itself with video games, could yet deploy itself if the economy grows as expected and stop wages from rising.
A rising trend in bond yields and inflation would be a big deal. It would take most of us into uncharted territory. This is not yet a done deal.
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