James W. Paulsen, Ph.D. Perspective Bringing you national and global economic trends for more than 30 years Economic and Market January 27, 2015 Does a 2% 10-year U.S. Bond Yield Make Sense When... For the second time in this economic recovery, the 10-year U.S. government bond yield has fallen below 2%. Although economic issues about the globe remain prevalent, the U.S. economy is notably better compared to when the 10-year Treasury yield was last below 2%. Global economic concerns notwithstanding, is the 10- year bond yield justified in suggesting conditions are currently worse than at any time in this recovery even though U.S. economic performance is arguably at its best? While international economic relationships cannot be ignored, this note highlights how out of line the current 10-year bond yield appears relative to several domestic economic measures. While predicting a bottom in either oil prices or bond yields has proved a loser s game, we think investors should stay vigilant this year about the potential for higher U.S. yields. Sometimes bull markets rise by so much for so long that even outrageous prices (or yields) can seem (and be justified as) normal. Today, yields hovering about the lowest levels in U.S. history are justified (legitimately?) by widespread international economic concerns. However, since domestic yields seem increasingly disconnected from the performance of the U.S. economy (as the examples below illustrate), the 10-year U.S. bond yield could quickly appear absurdly low should international economic concerns ease during 2015. gains for most of the past 75 years while recessions have occurred less than 20% of the time during the last 35 years. And yet, the 10-year yield is currently below 2% while during the late 1800s, it never fell below 3%! Clearly, several international economies struggle with weak growth today and the U.S. Fed has employed unprecedented monetary policies during this recovery which could be distorting bond yields. Nonetheless, U.S. real GDP growth has been between 3.5% and 5% in four of the last fi ve quarters, the unemployment rate is now at only 5.6% declining by about 1% a year for the last three years, consumer sentiment recently rose to an 11-year high, auto sales are near a 17 million annual pace, bank lending has risen at about an 8% pace in the last year, and both corporate profi ts and the U.S. stock market are near all-time record highs! Does this sound like an economic environment which should legitimately have a 10-year bond yield lower than it was at any point during the Great Depression? The historical comparison provided by Chart 1 brings to mind several adjectives describing the current 10-year Treasury bond yield ridiculous, absurd, ludicrous, wacky, and bubblelicious! Chart 1: Bond yield versus Consumer Price Index Left scale 10-year U.S. Treasury bond yield (solid) Right scale U.S. Consumer Price Index, natural log scale (dotted)... It was never this low at any point during the Great Depression? Is the economy today worse than during the Great Depression? As illustrated in Chart 1, the current 10- year bond yield at slightly below 2% is lower than at any time during the 1930s! Indeed, it is lower than at any time since at least 1870! Is economic growth weaker, is the unemployment rate higher, is bank lending slower, is economic confi dence in the future more bleak, or is price defl ation more severe than it was in the Great Depression? Why, then, is the current 10-year Treasury yield lower? Furthermore, between 1870 and 1900, the U.S. consumer price level fell almost continuously (i.e., chronic defl ation) and the economy experienced frequent recessions (about 50% of the time). By contrast, today, the U.S. has experienced uninterrupted consumer price
2... It offers virtually no buffer to the current rate of core consumer inflation? Historically, as shown in Chart 2, the 10-year bond yield typically is about 2% to 4% above the core consumer price inflation rate when in equilibrium with the economic recovery. But, the bond market has often been out of sync with the economy for extended periods. Chart 2: Real 10-year Treasury bond yield* *10-year Treasury bond yield less annual core consumer price inflation rate For example, in the late 1960s through much of the 1970s, bond yields were chronically too low primarily because actual inflation rose faster than expectations and this disequilibrium correctly suggested a risk of rising yields. Similarly, in the early 1980s and again at times throughout the 1990s, the 10- year yield was often too high relative to the economy mostly because fears of imminent inflation persisted far longer than actual inflation risk. Similar to the 1970s, bond yields which persisted above equilibrium levels ultimately correctly indicated an eventual trend of lower yields. Throughout this recovery, the 10-year bond yield has been below equilibrium levels. In contrast to the 1970s, however, today, bond yields remain too low because fears of deflation are much more pronounced than the actual inflation realities. The U.S. bond market already appears priced for significant deflation with the current 10-year bond yield only slightly higher than the 1.6% core inflation rate. In equilibrium, the 10- year yield should be at least 2% above the core inflation rate, or at least 3.6%. Being so far below equilibrium, how would U.S. bond yields react if the accommodative policies recently employed about the globe successfully boost international economic growth and calm fears of a deflationary spiral? How quickly and aggressively would U.S. bond investors rush to re-establish a yield buffer against potential inflation in the U.S.?
3... Now that confidence has recovered to an 11-year high? As Chart 3 shows, bond yields have been closely tied to consumer confidence. Since 2000, chronic bouts of fear have driven investors toward the safe-haven U.S. Treasury bond. Chart 4: Bond yield versus nominal GDP growth 10-year U.S. Treasury bond yield (solid) Annual nominal GDP growth (dotted) Currently, though, while the 10-year yield has declined near all-time lows, consumer confidence has surged to an 11-year high! As this chart implies, U.S. bond yields did not decline in 2014 because of concerns about the domestic economy. Rather, Chart 3 highlights just how much U.S. yields have recently been impacted by international fears. Consequently, international concerns represent the biggest 2015 risk facing domestic bond players. If international anxieties ease this year, bond yields should increase. However, they could rise much more than appreciated. If global deflationary worries evaporate, domestic bond yields will likely catch up to a much improved level of confidence in the domestic economy. Chart 3: Bond yields versus consumer sentiment Left scale 10-year U.S. Treasury bond yield (solid) Right scale University of Michigan U.S. Consumer Sentiment Index (dotted) Throughout this recovery, the 10-year bond yield has remained lower than the pace of nominal GDP growth. Perhaps, the relationship has returned to what it was prior to the 1980s. Between 1961 and 1979, the median amount by which nominal GDP growth exceeded the 10-year bond yield was 2.7%. As of the third quarter of 2014, annual nominal GDP growth is 4.3% suggesting a reasonable 10-year bond yield (based on the historical post-war relationship prior to 1980) of about 1.6%, which is very close to today s yield of about 1.8%. However, annual nominal GDP growth is poised to accelerate. This is because 2014 s first quarter contraction in real GDP will soon be dropped from the calculation and also because U.S. economic growth has been noticeable faster in recent quarters. We estimated annual nominal GDP growth through the first quarter of this year assuming quarterly nominal GDP growth averages 5% during the last quarter of 2014 and the first quarter of 2015 (i.e., essentially about 3.5% real growth and 1.5% pricing gains).... Nominal GDP growth is headed above 5%? Chart 4 compares the 10-year bond yield with nominal GDP growth since 1960. During the last several decades of persistent disinflation, the 10-year bond yield has hovered about the annual pace of nominal GDP growth. Conversely, between 1960 and 1980 when inflation chronically rose, bond yields almost always trailed behind the pace of GDP growth. Because the pace of GDP growth is likely to accelerate, even the historical (pre-1980s) relationship between bond yields and nominal GDP growth could soon suggest the 10-year yield is too low. If annual nominal GDP growth rises to 5.8% by spring (as illustrated by Chart 4) and the 10-year yield trades at its median discount to GDP growth in the pre-1980s era, a reasonable 10-year Treasury bond yield would be 3.1%. That is, should nominal GDP growth rise above 5% in 2015, a 10-year bond yield below 2% could quickly appear extraordinary low.
4... When real U.S. bank lending is rising at almost a 6% annual pace? Until last year, bank loans were virtually nonexistent in this recovery helping to keep interest rates low. However, as shown in Chart 5, credit creation has finally come to life as the annual growth in real bank loans has risen by almost 6% in the last year. Not only is this the strongest bank lending of the recovery, it is also one of the fastest growth rates since 1980! Does it make sense the 10-year yield (and the federal funds interest rate) is hovering about all-time record lows when real loan growth is rising at one of its strongest paces in the last 35 years? Chart 5: Annual growth in real U.S. bank lending* *Annual growth in ratio of total U.S. bank loans divided by core Consumer Price Index... When the U.S. labor market is healthier than at any other time in this recovery? Chart 6 highlights a close relationship between the performance of the U.S. job market and the 10-year bond yield. The dotted line is the annual growth in a ratio of aggregate labor market payrolls (i.e., wages x hours worked x number employed) divided by the U.S. unemployment rate. Essentially, when this ratio rises, payroll growth is accelerating relative to the available labor supply (i.e., relative to the unemployment rate). As shown, six other times since 1982 when the annual growth in this ratio has risen above 15%, it provided a good signal of a near-term bottom in the 10-year yield. In early 2014, this indicator again rose above 15% and has continued to strengthen. However, bond yields have so far continued to decline. By most measures, the U.S. job market is the strongest of the recovery. As illustrated in Chart 6, should bond yields be near all-time lows when job market performance is at its best of the recovery? Chart 6: Bond yields versus labor market indicator Left scale 10-year U.S. Treasury bond yield (solid) Right scale Annual growth of U.S. aggregate weekly payrolls (average hourly earnings X average weekly hours X employment) divided by U.S. unemployment rate (dotted)
5... When there is still room for U.S. yields to rise relative to foreign yields? Many believe the 10-year U.S. Treasury yield is anchored by low foreign yields. However, as Chart 7 shows, the current ratio of the U.S. 10-year yield to the average G-6 yield is only 0.79 compared to its peak since 1993 at slightly more than 1.5. Even if foreign bond yields remain unchanged at the levels they are at today, the U.S. 10-year yield could independently rise to about 3.5% and still be within the range relative to the G-6 average yield which has existed since the early 1990s. Moreover, foreign yields should rise some this year if, as we expect, international fears calm. That is, U.S. bond yields could rise considerably this year whether or not foreign bond yields also rise. Chart 7: U.S. 10-year international bond yield spread* *U.S. 10-year Treasury bond yield less average G-6 (Canada, France, Germany, Italy, Japan, and U.K.) 10-year government bond yield Summary??? Bond yields have fallen about the globe in the last year as deflationary fears have escalated. In contrast to earlier times in this recovery, however, U.S. bond yields have declined despite significant improvements in the domestic economy. The U.S. unemployment rate has fallen nearer to full employment at 5.6%, monthly job gains have averaged a recovery best 252K in the last year, auto sales have soared to almost a 17 million annual pace, real GDP growth has risen between 3.5% and 5% in four of the last five quarters, and consumer sentiment recently soared to an 11-year high! As this note illustrates, relative to several domestic economic indicators, the current 10-year bond yield appears extraordinarily low. That is, the contemporary global deflation scare has seemingly divorced the current U.S. yield structure from the performance of the U.S. economy. Will this persist? Will current economic struggles evident about the globe eventually cause the U.S. expansion to stall? Indeed, bond yields in the U.S. already seem to reflect a significant U.S. slowdown. Alternatively, how will U.S. bond yields respond should current international economic concerns (deflation fears) ease this year? As the relationships discussed in this note insinuate, without deflation contagion concerns, U.S. bond yields probably would already be considerably higher and more appropriately connected to an expanding and much improved U.S. economic recovery Predictions calling for higher yields have become tiresome during this recovery (my 2014 call included). However, we still think bond investors should remain mindful on just how much the U.S. 10-year yield appears remarkably out of sync with a significantly recuperated U.S. economy.
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