The benchmark 10-year Treasury rate edged up to 3.0% yesterday (April 24) for the first time since 2014, based on daily data published by Treasury.gov. It’s just another number, but the milestone is widely viewed as another sign that the secular bull market in bonds that’s prevailed for decades has ended.
The news inspires a fresh review of what regime change for the direction of interest rates implies for financial markets and the economy. That’s always a challenging task and it’s unusually tough at the moment, thanks to several crosscurrents on the economic, financial, geopolitical fronts. There are no easy answers, but there are some obvious questions to consider as the crowd ponders a future framed by the possibility that Treasury yields are set to trend higher on an extended basis for the first time in nearly 40 years. With that in mind, here’s a rundown of issues that come to mind for deciding if we’re truly on the cusp of a new era – or just spinning our wheels in yet another phase of the post-2008 world that brings more of the same.
Is this another head fake?
Despite all the talk of regime change, a long-run chart of the 10-year rate leaves room for wondering if the latest uptick is noise. Sure, 3.0% looks high if you’re looking at history from the perspective of the last several years. But from the 30,000-foot view, the latest uptick looks insignificant, at least for now. Although rates have popped from recent lows, it’s possible that higher yields remain range-bound in the months (years?) ahead until/if economic growth and/or inflation heat up.
Will economic growth accelerate?
A forecast of a secular rise in interest rates from current levels implies that US economic growth will at least hold at a moderate pace. But the expansion is now in its ninth year, one of the longest on record. Meantime, the GDP trend of late, while still firmly in the growth camp, doesn’t look set for an upside breakout. This Friday’s preliminary look at first-quarter GDP data is expected to show a deceleration in growth to 2.0%, according to Econoday.com’s consensus forecast – the softest rise in a year. Optimists predict that a rebound will arrive later in the year. Perhaps, but if the forecasts are correct about the upcoming Q1 GDP report, the news could take a bite out of the upside momentum for the 10-year rate in the near term.
Is inflation finally trending up?
A sustainable rise in the 10-year implies that inflation will trend higher. Consumer inflation has certainly ticked up lately, but it’s unclear if the latest bounce marks a new era or just the upper range of an ongoing period of relatively weak pricing pressure. A key metric to watch in the months ahead: core CPI, which has popped up to a 2.1% year-over-year rate through March – the highest in a year. But we’ve been here before in the years since the last recession and so it remains to be seen if core CPI’s trend can break into higher terrain. A game-changer would be if core CPI reaches a 2.4% annual pace, which would mark a new peak for the current expansion.
Will the Federal Reserve reconsider future rate hikes?
The central bank is certainly aware of the linkage between tighter monetary policy and recessions. The question is whether that tortured history will influence policy in the months and years ahead. Keeping the expansion alive and well is a high priority for the Fed. But the current economic climate is challenging for several reasons, including the mop-up project in the wake of the extraordinary policy decisions over the last decade. The economy is growing, but the crowd is becoming anxious, as this year’s weakness in the stock market suggests. The question before the house: Will the Fed continue to raise interest rates if the stock market continues to slide? Wall Street is hardly the only factor for setting monetary policy. But it would be strange to see the Fed raising rates while stocks are tumbling. Regardless, Fed funds futures are currently pricing in another rate hike for the June FOMC meeting, according to CME data. Will that forecast be revised if the US stock market slumps further in the weeks ahead?
How will geopolitical risk influence Treasury yields?
Even if US economic growth and inflation edge higher, world events could intervene to keep a lid on the 10-year yield. Numerous risk factors are bubbling, ranging from a potential trade war between the US and China to a simmering powder keg of geopolitical risk in the Mideast as Iran, Turkey, Russia, Israel and the US weigh their options regarding Syria. For the moment, the markets are looking elsewhere. But the simmering civil war in Syria still holds the potential to create a much wider field of chaos that triggers a rush into safe havens bonds, which in turn keeps Treasury yields contained.
Will a recession at some point intervene?
The risk of a new downturn remains low, but one can only wonder if the aging expansion will at some point hit a wall. The business cycle doesn’t follow a clock, but a recession would surely reshuffle any expectations for a secular rise in interest rates. For now, there’s no sign of trouble on the US macro front. When and if that profile changes, so too will the outlook for Treasury yields. Indeed, history reminds that softer economic growth (or contraction) tends to be accompanied by lower interest rates.