Rising Treasury Yields Are Not a Threat to the Economy

I've been predicting much higher Treasury yields for most of this year, and I recall saying in a comment, in response to a reader's question, that when 10-year Treasury yields reached 4% that would be a good sign that the market had accepted the fact that the economy was in recovery mode. And that's essentially where we are today.

I've also maintained that rising Treasury bond yields were a good thing, and not a threat to the economy as so many seem to be arguing these days. That's because yields have been rising mainly because the economy is recovering instead of collapsing, and deflation is essentially dead; recall it was the fear of depression and deflation that drove 10-year yields to 2% at the end of last year. We've come a long way since then, and that's a good thing. We're not sliding into a depression, were beginning to grow again.

I've also said that there was a Perfect Storm developing that could send T-bond yields sharply higher: a recovering economy, rising inflation, and massive sales of Treasuries to finance Obama's trillion-dollar deficits. That sounds pretty scary, but the storm could bring with it the much-needed realization on the part of politicians and the press that we have got to rein in the spending impulse that seems to have rendered every Democrat in Washington an Obama-zombie. We don't need to spend $800 billion in stimulus money, because the economy has recovered on its own. We don't need to goose the federal budget either. And with social security and medicare already facing giga-deficits in coming years, we don't need—and most certainly can't afford—to expand federal healthcare spending any further.

Back to yields: thanks to a significant narrowing of credit spreads, the 2 percentage point rise in Treasury yields this year hasn't resulted in any significant increase in borrowing costs for the private sector. Junk bond yields have fallen by roughly 6 percentage points since the end of last year, and investment grade bond yields are roughly unchanged. Mortgage rates are up from their all-time lows, but they are still well below the levels that prevailed during the housing boom. I don't see why 5.75% fixed mortgage rates have to be a threat today, considering that they averaged 6.65% over the past 13 years, according to BanxQuote. Consider also that yields are up in nominal terms, but real borrowing costs (after adjusting for inflation) are still relatively low, and could go lower if inflation rises.

What the Fed needs to do is to start withdrawing the $1 trillion it has added to the money supply, as Art Laffer explains in his WSJ op-ed. If they took credible steps to avoid the huge rise in inflation that threatens, that would boost confidence and boost the dollar, and that would result in more investment and a stronger economy. This is not the time to go wobbly in the face of higher yields.

Comments

[Dave Wrixon:]

No, Treasury Yields are rising because investors are not happy with the risk for a 2% yield, frankly they are even less happy at 4%, so things will go a lot higher yet. It won't take the central bank to raise interests in the face of hyper-inflation. The market will do that all on its own.

Of course there will be secondary effects. The US Government will have to start making efforts to balance the books. The Fed will have to stop QE because the dollar is free fall. And the Retail Banks will be on the rocks again as the Housing crashes once again. But it sounds like the only recovery you are interested in is on the Stock Market and that may run for a while as the sentiment driven by increasing share prices is self-staining.

Jun 11 06:24 AM

[Wesley Mouch:]

The idea that higher yields are tolerable misses the fundamentals of the current situation, IMHO. The entire appearance of recovery is wholly predicated on reflation, not on fundamentals, or improving demand. This entire rally is based on nearly free money.

Rising interest rates across the curve will dampen the appearance of the residential real estate recovery (only the appearance, as there never was a real recovery anyway), and will not allow Commercial Real Estate, State, County, Municipality and Corporate refinancing when it is needed most. Do we really believe that if the Obama administration announced a balanced budget (based on predicted tax receipts this year, the budget would be slashed from last year's) and if the FED stopped its total life support of the banking system through its depression era power acronym programs, that there would be any appearance of recovery?

Jun 11 08:20 AM

[Old Trader:]

I suspect the short end yields are dropping because buyers want no part of long-dated securities, given the flood of the same looming, not just here, but world-wide. Rates will keep getting bumped on the long end as an "inducement" to potential buyers, which will add pressure on mortgage rates, stifling any nascent recovery in real estate.

It probably won't be too long before we look back at the current 5.75% mortgages as the "good old days". (You are correct, though, in saying 5.75% is on the low side, historically speaking).

Jun 11 10:52 AM

[Mad Hedge F...:]

Not now, but they will be. Just another update on my core short in long dated US Treasury bonds, the TBT, which hit a new high for the year of $60, up 72% from my initial call (www.madhedgefundtrader...). The nine to eleven year note auction went off OK, despite its enormous size. What drove the yield on the ten year to a seven month high of 3.99%, the 30 year to 4.67%, and herded buyers into the TBT was the May US budget deficit of $190 billion, an all time record, despite massive inflows of income tax revenues. There was also word that Russia didn’t want to buy any more US government debt because they hated the dollar. After having spent four decades on the front lines of the cold war, I have to pinch myself when I hear stuff like this. The news sent equities on a 200 point intraday swoon. If higher rates and $70 crude don’t go away, they are going to kill the stock market. Everyone is holding their breath for the 30 Treasury bond auction tomorrow. The time to pay the piper is coming, and his rates are going up.

Jun 11 10:54 AM

[Economic Da...:]

I agree with pretty much your entire view on this. Well put. I'm actually long oil, long equities, and short treasuries. So far so good.

Jun 11 11:08 AM