Bill Gross, the bond investor, is setting the tipping point at 2.60 percent. That is, Mr. Gross says, that if the yield on the 10-year Treasury note goes above 2.60 percent, it will "break a trend line that has been in place since the late 1980s…."
A "bear-market" for bonds would then follow. The question becomes, what might take the yield on the 10-year Treasury above this level. There are two ways to look at this right now.
First, looking at Treasury "break-even" yields, we are now interpreting that the market expects, over the next ten years, that the inflation rate of the United States economy will come in around 2.00 percent.
This rate of inflation is consistent with the policy objective of the Federal Reserve System to keep inflation at or around 2.0 percent.
The officials of the Fed are, themselves, forecasting that the inflation rate will not get above 2.0 percent in either the short-run or in the "longer run."
This, market estimated, estimation of inflationary expectations has remained around 2.0 percent ever since early November 2016 when Donald Trump was elected to be the president of the US.
If we keep inflationary expectations at this level going forward, this would mean that the estimated yield on the Treasury's 10-year inflation protected securities (TIPS) would have to be 60 basis points or more.
As the yield on the 10-year Treasury note rose following the Trump victory from about 1.80 percent to 2.60 percent around the middle of December, inflationary expectations rose by about 20 basis points and the yield on the 10-year TIPs rose by 60 basis points from around 10 basis points to around 70 basis points.
Since the middle of December, although inflationary expectations have not changed, the yield on 10-year TIPS, has dropped by about 20 basis points. The yield on the nominal 10-year Treasury note from the 2.60 it hit in December to the around 2.40 percent where it now resides, all of the decline coming in the TIPS yield.
Thus, for the market to reach the "tipping point" highlighted by Mr. Gross, keeping inflationary expectations constant, a rebound would have to occur in the yield on TIPS. The question then becomes whether or not we might expect a rise in this yield?
Economists look at the yield on TIPS as the "real" yield on bonds, that is, the yield earned after taking into account inflation. In economic theory, the "real" yield on bonds should bear some relationship to the expected "real" rate of growth of the economy.
In the period before the Great Recession hit, the yield on the 10-year TIPS was somewhere around 2.00 percent, a little lower than the actual real rate of growth achieved by the economy. If this type of relationship were to hold, going forward, then one might expect that the yield on the 10-year TIPS might be somewhere around 1.70 percent to 1.90 percent, given that the real compound rate of growth of real GDP has been around 2.1 percent during the current economic recovery, which is not significantly different from the projections by Federal Reserve officials, projections that are provided in the reference cited above.
However, there is another factor impacting the level of TIPS yields at the present time. A lot of foreign money has found a home in US Treasury securities in recent years as investors' search for a "safe haven" has resulted in the yield on TIPS being substantially below estimates for the future real economic growth of the US. This flow of money has even taken the TIPS yields into negative territory from time-to-time.
So, assuming that inflationary expectation remains constant around 2.0 percent, expectations are going to have to change about economic growth or the "safe haven" money in the United States is going to leave, so that the yield on the TIPS will rise to 60 basis points or more.
Right now, economic growth is really not expected to rise much from the 2.0 percent to 2.5 percent now being projected. New projections, just put out by the World Bank, show that the United States is projected to grow by only 2.2 percent in 2017. Thus, it is hard to see the rise in the yield on TIPS coming from stronger US growth.
"Safe haven" monies would flow out of the United States in one of two situations: First, if the rest of the world became safer or sounder, something that doesn't seem to be forthcoming at this time; and second, if the United States becomes a "less safe" place for world investors to place their funds.
Only a Trump meltdown might cause this latter event to take place where funds fled the US.
Otherwise, the expectations are for the Fed to raise their policy rate of interest, possibly three times, in 2017. This would give investors more reason to keep their money in the US rather than take them elsewhere and this would keep the yield on the TIPS at the lower rates.
This gets us to the second reason why interest rates might rise: A rising term structure of interest rates resulting from the Fed moves on short-term interest rates. Just before the election, the yield differential between the 2-year US Treasury note yield and the 10-year yield was right around 100 basis points.
By the middle of December, as the yield on the 10-year Treasury peaked around 2.60 percent, the spread was almost 140 basis points… that is, the slope of the yield curve became steeper. Currently, the spread is back to around 120 basis points.
In a rising rate market, the yield curve should flatten. Whether or not it does is going to depend upon how fast the market perceives that Federal Reserves are going to raise interest rates. I don't believe, at this time, that market participants think that Fed officials will cause short-term rates to rise fast enough to force the longer-term rates that much higher.
The only reason that this would happen is that the Fed believed that inflation was getting "out-of-hand" and presenting the possibility that price increases would begin to exceed the Fed's target rate of inflation, 2.0 percent.
We have assumed this possibility away in the earlier discussion about where the bond market might be going. And this, I believe, is Mr. Gross's ultimate point. If inflation were to get out of hand, the yield on the 10-year Treasury would rise above 2.60 percent, indicating that the "bull market" for bonds was definitely over and that the "bear market" was at hand.
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