- 10-year yield versus MZM Velocity.
- 10-year yield versus the 3-month yield – long-term.
- 10-year yield versus the 3-month yield – shorter-term.
The fear, or concern, that interest rates might move higher is healthy. It suggests that some of the lessons from the stagflation of the 1970's have been remembered. The 1970's inflation spiral had a number of factors. Energy prices spiked as a source of supply was cut without a reduction in demand. Gold price surged as a new source of demand hit the market, the legalization to own gold in the US, while the supply growth lagged. Today the U.S. has undergone a change with the growth in energy supply matching or exceeding the growth in demand. This has kept energy prices somewhat stable.
History would suggest, (see chart), that for the 10-year U.S. Treasury yield to move higher that the trend in MZM money supply growth must improve, or maybe stabilize. The MZM velocity has been falling for many years, as have interest rates.
The trend in the velocity of MZM Money Supply and the 10-year U.S. Treasury bond yield has been trending down since the early 1980's. This period that has been generally favorable for bondholders. When the velocity of MZM increased, from the 1960's to the late 1970's, it was generally a challenging environment for bondholders. It should be noted that bond investors will enjoy a higher than expected total rate of return when interest rates move higher thanks to a higher reinvestment rate.
The longer-term view of the 10-year less 3-month yield spread. Historically there has been a well-defined range of the spread. Currently the spread is nearer to top of the range than the bottom of the range. See chart below.
The 10-year less 3-month yield spread being near the top of the historical range suggests that in order for the 10-year yield to move higher, that the yield on the 3-month Treasury bill must move higher. Given the desire of the Federal Reserve to keep short-term interest rates low, the ability of the 10-year yield to move sharply higher versus the 3-month T-bill may require a move not historically seen.
The shorter-term picture of the 10-year less 3-month spread is shown below.
It would appear that the spread relationship has been range bound and at the moment has stabilized or is trending downward.
Inflation may find a difficult time gaining traction with the current rate of capacity utilization. With excess capacity, firms may find it difficult to increase prices without a pickup in demand. The unemployment rate may find it difficult to improve without a pickup in demand. The Federal Reserve may be pushing on a string, by pumping money into the system, with borrowers reluctant to use the monies to increase employment. The increased and uncertain regulatory environment with unknown cost burden may hinder the prospect of increased employment.
Equity investors like to remind fixed-income investors that inflation is harms returns. It is true that inflation harms returns of bondholders and stockholders. However, since inflation entered a disinflationary mode in the 1980's, bondholders have fare well. History suggests that nothing lasts forever and markets change. What equity investors may not realize or appreciate is that bondholders take less financial risk relative to stockholders. Therefore, less risky bonds should yield less than the more risky stock dividend yield. The fact that the Federal Reserve has kept short-term, overnight, interest rates low is rational. Investors that prefer instant liquidity should earn less than investors willing to tie up capital for longer periods, right? The risk-reward calculation differs for every investor. The increase of debt on corporate balance sheets may hinder stockholder returns. For example, Coca-Cola (NYSE:KO) has seen its long-term debt climb from $1.157 billion (2004) to $19.154 billion (2013) while interest expense grew from $196 million to $463 million. How did stockholders fair? The market value increased from $123 billion (Feb 2004) to $165 billion (Feb 2014). The change in market value for the decade was 34.2%, or 3.42% per year. The 10-year U.S. Treasury had a 4.00% yield during February 2004. It should be noted that Coca-Cola spent $27.6 billion repurchasing shares during the period.
Source data for Coca-Cola is SEC filings, balance sheet and cash-flow statements.
Bottom-line, for the 10-year yield, or the 3-month T-bill yield, to move higher economic growth may need to surprise to the upside and or inflation may need to accelerate. The regulatory headwinds may assist with cost-push inflationary pressure; however, the slack in capacity utilization, unemployment over-hang, and debt burden may provide pressure that is more deflationary. This may result in a longer than expected range bound interest rate market environment.