There are no certainties in life, and much less so in financial markets. One’s life can end tomorrow, and so can the planet.
When speaking of future states of affairs that depend on human action, all “truth claims” as philosopher term it, are of a probabilistic sort.
Having said that, as propositions about future states of affairs go, I think that the notion that 10-year Treasury yields (^TNX, TLT) will rise from the current level of around 2% to above 4% (at least) within the next two years (at most) has about as high a probability as can possibly be assigned to any statement regarding the future value of a financial asset.
Three Outcomes, the Same Result
I believe that there are only three plausible economic outcomes (with their sub-variants) that can be reasonably derived from the current state of economic affairs in the U.S. and the world at large. All three outcomes will ultimately entail substantially higher long-term U.S. Treasury yields.
Outcome #1: U.S. Economy Recovers
In this scenario, long-term Treasury yields (^TNX, ^TYX) will rise substantially.
Current annualized inflation in the U.S. is running at 3.6%. Any economic recovery in the U.S. within the next two years will entail annualized CPI inflation of no less than 3.0%. Not only do the economic fundamentals dictate such a result, Fed policy is explicitly oriented to insuring that “core” inflation stays above the 2% “comfort zone” so as to protect against any possibility of deflation.
Due to resource constraints around the world and burgeoning demand from emerging countries, in an environment of even modest global growth, the CPI including food and energy is almost certain to run at a pace that is greater than “core” CPI for most of the coming decade.
Given this moderately inflationary context, 10Y bond yields would certainly rise well above 4.0%. Indeed, there are no historical precedents for the real (inflation-adjusted) rate of return on U.S. Treasuries to be sustained for long periods below 2% in the midst of an economic recovery and relatively low inflation.
As recently as a little over three months ago, despite anemic growth expectations, and much lower inflation rates at that time, 10Y Treasury yields were at around 3.6%.
Outcome #2: U.S. Economic Recession and Debt Default
The US economy cannot afford a recession right now. The fiscal deficit is already running at an unsustainably high 8%-9% of GDP. A recession would cause tax receipts to collapse and cause outlays for automatic spending stabilizers such as unemployment insurance, nutritional support, Medicaid and the like to spike higher. The budget deficit could balloon to an unprecedented 12% of GDP or higher.
This level of budget deficit would be perceived by market participants as being utterly unsustainable and not financeable. Few creditors would lend money to the U.S. Treasury at low rates under these circumstances.
With default risk rising exponentially, yields on long-term Treasuries would tend to spike, much as they did recently in the case of Spain and Italy.
Incidentally, it should be noted that both Spain and Italy are currently running much lower budget deficits than that of the U.S. as a percent of GDP and magnitudes lower as a percent of total fiscal revenues.
Outcome #3: U.S. Economic Recession Followed by Fed-Engineered Inflation
It is extremely unlikely that the U.S. will ever default on its public debt. The reason is simple: The U.S. has a fiat monetary system that can effectively serve as a guarantee that such an outcome never occurs. Indeed, the Fed has a legal mandate to promote full employment. Both from a legal and political point of view, the Fed cannot sit idly by and allow a deflationary default scenario to transpire since it would entail unemployment rates of over 20% and under employment north of 30%.
Furthermore, ever since the publication of A Monetary History of the United States, by Milton Friedman there has been a virtually unanimous consensus among economists and policy makers in the U.S. that it is far preferable for the U.S. to risk inflation through aggressive monetary intervention than to allow another Great Depression. Indeed, the current Fed Chairman Ben Bernanke has been widely recognized as leader of academic and policy opinion in this regard during the past decade.
Readers would be well served to peruse Bernanke’s speech entitled, “Deflation: Making Sure that ‘It’ Does Not Happen Here.” In that speech Bernanke made the following unambiguous remarks:
"The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand - a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending - namely, recession, rising unemployment, and financial stress."
Bernanke then went on to describe a dizzying array of policy options to combat the decline in aggregate spending that is at the root of a deflationary environment. In this article
I summarize Bernanke’s various policy proposals.
Bernanke discussed a truly fantastic array of options including targeted currency depreciation through purchase of foreign currencies, ZIRP, equity purchases and much more. It makes for fascinating reading – a veritable dystopian brainstorm. However, perhaps the most important and highly revealing remedy that Bernanke discussed was the following:
"The U.S. government has a technology, called a printing press, that allows it to produce as many dollars as it wishes at essentially no cost." "Under a paper-money system, a determined government can always generate higher spending and, hence, positive inflation."
Thus, it should be abundantly clear that before allowing the U.S. to fall into another Great Depression and associated deflation the U.S. Fed will aggressively propitiate an inflationary environment that will allow the government to make its debt payments and reactivate aggregate demand.
There can be little room for doubt that under such inflationary circumstances, nominal yields on U.S. Treasury bonds would rise sharply.
Scenarios In Which Bond Yields Would Not Rise
There are essentially two scenarios (and sub-variations) under which long-term Treasury bond yields conceivably might not rise from current levels within the next two years. I consider these scenarios to be of extremely low probability.
Japan-style muddle-through. In Japan, long-term bond yields stayed extremely low for very long periods of time. Many hypothesize that same outcome for the US in the coming decade. However, there are extremely powerful reasons to surmise that such an experience will not be repeated in the U.S.
First, savings rates in Japan were and are extremely high. This excess savings was the key factor that kept long-term interest rates low. Another key was the particular nature of the Japanese savings culture and corresponding nature of Japanese savings institutions such as the postal service. The U.S. does not enjoy anywhere near this degree of “captive” financing. Indeed, the U..S depends on a highly fluid financial system and potentially unreliable foreign sources to finance its deficit.
Second, there is a virtually unanimous academic and policy consensus in the U.S. that the Japanese central bank and central government were not nearly aggressive enough in combating the contraction of aggregate demand and the concomitant deflationary environment. The consensus of academic and policy opinion in the U.S. is that if faced with a similar predicament, the U.S. Fed should be much more aggressive in stimulating inflation and aggregate spending. See Bernanke’s remarks above.
Rate caps. In his famous speech, Bernanke floated the idea of rate caps. This would involve the Fed targeting interest rates on a whole range of government and non-government securities. This would work through unlimited authority for purchases of U.S. Treasuries by the Fed plus the provision of unlimited guaranteed long-term 0% liquidity to banks in order to purchase non-governmental debt securities.
(It is important to note that it is not necessary that the Fed necessarily keep long-term interest rates at extremely low levels in nominal terms. The requirement is that the Fed keep long-term nominal rates near or below the inflation rate anticipated by the market.)
While a rate-cap scenario such as the one described above employed through unlimited purchase authority can certainly not be discarded out of hand, I believe that it is highly unlikely that the Fed would adopt such a policy before long-term rates had already spiked to dangerous levels, thereby forcing the Fed’s hand. Politically, such a drastic measure could only be justified in the event of an actual, and not an imagined spike in rates. The Fed would attempt many alternatives to keep rates down at reasonable levels before resorting to such a drastic contingency.
When one carefully examines the universe of possible scenarios that derive from the current state of economic and financial affairs, one arrives at the conclusion that the overwhelmingly probable path for yields on long-term Treasury Bonds is up. Yields can continue to spike downward in the short-term due to save-haven buying. However, such low yields cannot be sustained beyond a year or two, at most. Market expectations of plausible longer-term scenarios, including Fed interventions, will simply not permit rates to remain at such low levels for very long.
All plausible long-term scenarios point to higher long-term Treasury rates. If the U.S. economy recovers, rates will rise. If the U.S. economy falls into recession and default risk rises, rates will spike. If the U.S. economy falls into recession and the Fed takes aggressive action, inflationary expectations will rise and nominal bond yields on long-term Treasury securities will spike.
Indeed, option #2 and #3 could occur in succession. In other words, fear of default could drive an upward spike in rates. This would be followed by aggressive Fed actions alluded to above which would assuage fears of default but which would increase long-term inflationary expectations thereby maintaining yields at relatively high levels (although perhaps not in real terms).
In sum, betting on a rise in long-term Treasury Bond yields over the course of the next year or two – e.g. the 10Y to a level of 4% at minimum – strikes me as one of the highest probability trades that I have encountered in my investment career.
Accordingly, I am short TLT
and long TBT
. I will add to positions if yields fall further on safe-haven panic buying.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short TLT and long TBT and SBND.