Wednesday, 20 of June of 2018

Economics. Explained.  

Treasury Notes — 10-Year Maturity

April 27, 2018

The yield on the 10-year note has risen sharply in recent months as the economy has gathered momentum and market  participants fear a significant quickening in the rate of inflation.  When the 10-year hit the 3.0% mark the stock market panicked because long rates have not been at that level since 2013.  But the reality is that a 3.0% rate on the 10-year is still low.

During the past several business cycles the 10-year note has averaged 2.2% higher than the inflation rate.  With the yield on the 10-year note today at 3.0% and inflation at 2.4%, the real 10-year rate is 0.6% which is very low by any historical standard.

If the Fed keeps the inflation rate at its 2.0% target and the rate on the 10-year tends to average 2.2% higher than that, the yield on the 10-year should reach 4.2%, by the end of 2020.  While the markets have gotten jittery because bond yields have risen to the 3.0% mark the reality is that long rates are going higher in the months and years ahead.  But even a 4.2% rate in 2020 should not stall the expansion.

When will rates have risen high enough that the economy could dip into recession?  The yield curve — which is the difference between long-term interest rates and short rates — will give us a hint.

With the 10-year yield at 3.0% and the funds rate at 1.7%, the yield curve today has a positive slope of 1.3%.  When the Fed tightens aggressively short rates will move higher than long rates and the yield curve will “invert”.  When it does that is almost invariably a sign that the economy is about to dip into recession.  Note how in both 2000 and 2007 the curve inverted by 0.5% or so six months to one year prior to the onset of recession.  If the Fed does what it intends to do and pushes the funds rate to 3.5% by the end of 2020 and bond yields at that time are 4.2%, the curve will still have a positive slope of 0.7%.  Not a problem.

If the world evolves as described above, the funds rate will be slightly above its neutral level (3.5% vs. 3.0%) by 2020 which it is not anywhere close to the danger level of 5.25%.  Bond yields will presumably be 4.2% which is about average by any historical standard.  And the yield curve will have a positive slope of 0.7%.  Thus, 2-1/2 years from now there may still be no sign of an impending recession.

Things could go wrong, of course.  The economy could suddenly grow very quickly, and/or inflation could climb significantly above the Fed’s 2.0% target.  Either of those situations would push the funds rate sharply higher than expected and make the yield curve invert.  For us to make a recession call we need to see two things — the funds rate will need to be well above the neutral rate (probably 5.0% or higher), and the yield curve should be inverted.  Neither of those conditions seem likely to be met by the end of 2020.

Stephen Slifer


Charleston, SC

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