10-Year Treasury Note Hits 3% Again

Sep. 16, 2018 11:38 AM ETiShares TIPS Bond ETF (TIP), IEF8 Comments
John M. Mason profile picture
John M. Mason
15.84K Followers

Summary

  • The yield on the 10-year US Treasury note is testing a 3.00% yield again.
  • The fluctuations over the past four or five months have can be tied to international flows of risk averse monies moving from economies experiencing problems.
  • One can make an argument that the 10-year yield should be higher, but this might indicate the disequilibrium that exists within world markets that eventually need to be resolved.

The 10-year Treasury note topped 3.000 percent Friday, before closing to yield 2.992 percent.

Earlier this year, the 10-year bounced around the 3.000 percent level. Time-wise, this was in the latter part of April into the middle of May.

This was a period in which the US dollar was getting stronger seemingly because the US economy appeared to be growing faster, and this was translated, in financial markets, into the expectation that the Federal Reserve would continue to raise its short-term policy rate of interest.

The yield on the 10-year Treasury note rose on the expectation that all interest rates would continue to rise for the near future.

The current return to the 3.000 percent level appears to be tied to similar economic factors, although the value of the US dollar has fallen slightly during this period. There has been very strong information coming in from the labor market and wages seem to be strengthening. This has provided support for the expectation that the Fed will increase its short-term policy rate twice more this year…and possibly raise the rate even further next year.

But, there seems to be more at work than just these factors.

If one divides the nominal yield on the 10-year Treasury note into its two, conceptual components, the expected real rate of interest and the expected rate of inflation, one gets a different picture of what is moving the market.

The expected real rate of interest is estimated by using the yield on the 10-years US Treasury Inflation Protected securities, or TIPS. The expected rate of inflation is calculated by subtracting the yield on the 10-year TIPs from the nominal yield on the 10-year Treasury note.

Using this approach, one observes that inflationary expectations have changed very little since the beginning of May through the present time. The average rate of expected inflation from the beginning of May through Friday, September 14 is 2.12 percent with the range of outcomes running roughly between 2.11 percent and 2.13 percent.

Most of the fluctuation in the nominal yield during this time period was the movement in the yield on the 10-year TIPs. And, the reason for this movement seems to be the state of world financial markets and the movement of risk averse monies into safe-havens, the major one being the safe-haven called the United States.

In late May, I wrote about this movement of funds. The problem areas at this time seemed to be Italy, Spain, and Greece.

On May 15 the yield on the 10-year TIPs was 90 basis points. By July 1, the yield had dropped to 74 basis points, representing a fairly substantial drop.

And, the nominal yield on th 10-year Treasury dropped away from 3.00 percent during this time period.

In the last third of July, the international financial community was calmer and the yield on the 10-year TIPs rose to around 85 basis points. This brought the nominal yield back up to just under 3.00 percent.

Then the crisis around the Turkey Lira and the Argentine Peso hit. By the middle of August the yield on the 10-year TIPs dropped back to around 75 basis points and stayed there up until early September.

Then the yield on the 10-year TIPs jumped back up to 85 basis points…and then 88 basis points by the close of the past week as Argentina got assistance from the International Monetary Fund and Turkey’s central bank raised its benchmark lending rate to 24 percent, from 17.75 percent, when the market was looking for only a move to 22 percent. The crisis in the emerging markets seemed to be ending and the “nervous” money seemed to stop flowing toward the United States and other safe-havens.

It has been my argument that the yield on the 10-year TIPs has been unduly impacted in recent times by this international flow of risk-averse money. For one, the movements in the yield are just too closely tied to events throughout the world that have resulted in movements of risk averse monies. Thus, this yield has been kept below…substantially below…what the real rate of interest should be at this time.

Theoretically, the expected real rate of interest should be closely related to the expected real rate of growth of the economy. If one just uses the actual real rate of growth of the economy for the past nine years, the extent of the economic recovery since the end of the Great Recession, as an estimate of the expected rate of growth of the economy, one can argue that the real yield should be around 2.2 percent. The compound rate of growth of the economy since July 2009 is 2.2 percent.

Putting this expected growth rate with the expected rate of inflation one can argue that the nominal yield on the 10-year Treasury note should be around 4.3 percent.

If one argues that the expected real rate of interest should be about 40 basis points below expected rates of growth of the economy, roughly the relationship that existed for most of the 2000s before the Great Recession, this would put the expected real rate of interest around 1.80 percent. The expected nominal rate of interest should therefore be around 3.90 percent.

If one accepts this argument, it seems that the nominal 10-year yield should be substantially above where it now is. The difference between where the yield now is and where it could be is a result of the dislocations of money in world capital markets due to the difficulties experienced elsewhere in the world…Turkey, Argentina, Italy, Greece, and so forth…and the strength of the US economy and US financial markets.

I know that this 100 basis point difference seems like a lot, but it just may be an indication of the extent of the disequilibrium in the global economy. That is, the world has a lot of adjustment to make, and…sooner or later…the disequilibrium’s that exist will have to be dealt with. When and how this adjustment will take place is something we will have to look out for.

This article was written by

John M. Mason profile picture
15.84K Followers
John M. Mason writes on current monetary and financial events. He is the founder and CEO of New Finance, LLC. Dr. Mason has been President and CEO of two publicly traded financial institutions and the executive vice president and CFO of a third. He has also served as a special assistant to the secretary of the Department of Housing and Urban Development in Washington, D. C. and as a senior economist within the Federal Reserve System. He formerly was on the faculty of the Finance Department, Wharton School, the University of Pennsylvania and was a professor at Penn State University and taught in both the Management Division and the Engineering Division. Dr. Mason has served on the boards of venture capital funds and other private equity funds. He has worked with young entrepreneurs, especially within the urban environment, starting or running companies primarily connected with Information Technology.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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