The yield on the 10-year Treasury has crossed the 3% psychological barrier, signaling a steady rise in global rates and posing a challenge for riskier assets.
One way of telling the story of the past month is through interest rates, particularly yields on the benchmark 10-year U.S. Treasury. Rates have risen pretty steadily from the very beginning of April through mid-May. The 10-year bond yield crossed the 3% psychological barrier in April, setting a new five-year high and signaling that higher interest rates are ahead in the world’s biggest bond market amid the Federal Reserve’s intent on boosting interest rates. Fed officials’ most recent forecasts are for two additional rate increases in 2018.
Yields then broke through 3.1% on May 17, 2018. Rates were rising pretty much in lockstep with oil prices. That is not surprising because of the clear influence energy has on headline inflation. In fact, real rates were rising and not the inflation break-even rates (the break-even rate is applied to bonds and refers to the difference between the yield on a nominal fixed-rate bond and the real yield on an inflation-linked bond, such as a Treasury inflation-protected security). We think this oddity reflects trading patterns and liquidity; people were selling nominals, and it takes time for the break-even trade to happen when there are fewer active trading desks and smaller hedge funds.
As yields pushed through 3%, we had a number of conversations about whether this was the decisive move in long-term rates, the key break in the great bond bear market, or just the first stop on the march to 4%, 5%, or 6% yields. We continue to resist this idea for two main reasons, both of which came into play in the month.
Rising yields do matter
The first is that a rising real interest rate is a challenge for risky asset markets. There are circumstances in which yields and returns on risky assets can rise together such as when yields are being pulled up by strong returns on private capital. But for this to happen, more real sector investment is needed. When yields are pushed up by other factors, risky assets tend to decline. That’s exactly what happened in May; within hours of the real yield on the 10-year Treasury hitting a new multi-year high of 0.945%, the stock market was tumbling.
The second reason is that the equilibrium global real interest rate remains low. This is partly because of all the global supply and demand factors, including large current account surpluses in advanced, aging economies, and limited corporate demand for investable funds given current patterns of technological advance. These are not permanent features of the world economy. Although they are easing a little, they remain key factors. The low interest rates they have produced have encouraged debt accumulation.
Debt dynamics and higher rates
The debt accumulation creates a sensitivity to increases in interest rates. If debt is used to finance the installation of productive assets, then rising debt service costs don’t matter all that much. But if not, then the real resources needed to service debt can harm economic prospects and generate financial stress as defaults happen and assets are written down.
Those forces then tend to push rates down. This is exactly what happened in May. As U.S. yields rose, a number of emerging-market economies began to suffer. This is also what happened in Italy. As the risk premium on Italian debt rose to unsupportable levels, given the country’s debt level and economic prospects, German bond (or Bund) yields began to fall, pulling Treasury yields lower.
The strong economic recovery in the United States and a more determined Fed means U.S. rates could rise gently, even if this upward drift continued to be interrupted by rallies amid strains from the economy adjusting to higher rates. Bund yields will continue to be held back by high savings levels, a sluggish economy, and a cautious central bank.
Next: Spotlight on oil