As rates have risen, investors have, once again, started asking the perennial question: Is the bond bull market over and are rates normalizing? In thinking about bond yields, it is important to keep longer-term factors in mind that have nothing to do with central bank policy. Low yields have correlated with two, related longer-term trends: low nominal GDP (NGDP) and an aging population. The reason they’re related is that an aging population means slower growth in the workforce, and in turn, slower economic growth.
An aging population impacts rates through a second mechanism. As consumers age, their borrowing and investing patterns shift. Older households tend to borrow less and demonstrate a preference for income, in the process raising the demand and lowering the supply of bonds. The net result is that older populations tend to be associated with lower real, or inflation-adjused interest rates. This dynamic has been at work for decades and helps explain why low yields predated the financial crisis.
Because the population will not get younger any time soon, what would need to change to push rates back to “normal”? In terms of the real economy, the simple answer is faster nominal growth. Looking back over the past 60 years, the level of nominal growth has been the key to understanding the level of rates. During this period, a smoothed average of nominal growth explains almost 60% of the variation in long-term rates (see the chart below).
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“During a tightening cycle it is normal for short-term rates to rise more than long-term rates, resulting in a flattening of the yield curve. what is the yield curve signaling? Could it be that the growing chatter of a possible U.S. recession has some merit? Or are these fears overdone?
The Ground Rules
During uncertain times like these, we look to reliable indicators of past recessions to see what they are telling us. Although many variables such as growth in hourly earnings or high yield spreads over Treasury bonds have been shown to “predict” recessions in advance, the slope of the yield curve remains a powerful indicator of what lies ahead for the U.S. economy.
Perhaps I’m partial to this indicator because of its origin. I’ve had the privilege of having many good professors teach me throughout the years, standing on the shoulders of giants, if you will. One of these was Campbell Harvey, an investments professor of mine at the University of Chicago Booth School of Business. Professor Harvey wrote his dissertation thesis on how the slope of the yield curve predicts future economic growth.
In his dissertation, Professor Harvey measured the yield spread between 3-month and 5-year Treasuries and then compared the resulting yield curve to consumption growth. He discovered that when the yield curve inverts, such that short-term yields are greater than long-term yields, an economic recession can be predicted to occur 12 months later on average. Since Harvey first published this theory, the yield curve has inverted three more times (1989, 2000, and 2006) predicting subsequent U.S. recessions in 1990-1991, 2001, and 2007-2009. In each of these times, the Fed was in the midst of a tightening cycle.
At What Rates Could The Yield Flatten?
Using history as a guide, let’s take a look at three different methods for assessing the levels at which the yield curve has gone on to flatten or invert.
Fed Funds Rate
Historically, the Fed has stopped raising rates when the federal funds rate approximately equals U.S. nominal GDP, which is currently about 3.9% (2.4% plus inflation of 1.5%). If we assume that the sustained U.S. expansion continues at a modest pace and we move toward the Fed’s inflation target of 2%, then the Fed may complete its tightening cycle with the short-end of the curve ending up between 3% to 4%. Read more »
The Fed (and every other Fed commentator) uses the word “normalization” to describe the upcoming next phase of monetary policy. While the debate focuses on when that might be — as in, exactly how long is a “considerable period?” — we’ll simply say sooner than the markets expect. Now we can answer this question recently posed to me by a financial advisor: “What does normal mean?” “Normalization” refers to the two main components of the policy response to the 2008 financial crisis: quantitative easing (QE) and zero interest rate policy (ZIRP).
By “normalization” the Fed means returning its balance sheet to its pre-crisis size by exiting quantitative easing. That was last year’s story (the “taper tantrum”), and in the September Federal Open Market Committee meeting the Fed outlined its plans for how it intends to normalize its balance sheet. Leaving aside the many “inside baseball” details, the key implication of QE was that this policy was fundamentally directed towards reducing longer maturity interest rates. The Fed supported the housing recovery by targeting the QE programs at subsidizing mortgage borrowing costs. Hence, the exit from QE debated last year led to increases mainly in longer maturity interest rates.
“Normalization” means the end of ZIRP. This second part is more “normal” in that we can compare policy rates historically over past periods of Fed policy accommodation. Importantly, when considering the degree of policy accommodation historically, we need to look at the “real” fed funds rate (the nominal fed funds rate less the rate of inflation). Today, with inflation around 2%, current policy places rates at minus 2%.
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“All year the consensus regarding bonds has been that they are in a late stage bubble that is about to pop as long-term interest rates will rise and the price of bonds will sharply plummet. The consensus has been wrong. We saw a sharp spike in rates after Fed Chair Ben Bernanke first mentioned tapering QE3 in June, but the long rate has since come back down and currently stands at 2.51%. It seems the demise of the bond market has been a little premature.
Did the Fed Bail Out the Bond Market?
So what happened to the bond bubble that was supposed to pop? A few things have prevented a catastrophe for investors heavily allocated to bonds. The market had been anticipating the start of tapering of QE3, the Fed’s bond-buying program in which they have been purchasing U.S. Treasuries and mortgage-backed securities. Bernanke first mentioned tapering in mid-June and the 10-year rate jumped from approximately 2.20% to 3.0% in a very short time frame. This was a huge move for bonds, however, the market got ahead of itself as the tapering that seemed like a sure thing never materialized. The Fed kept QE3 unchanged due to what it felt was weaker-than-expected economic data. Since the non-tapering decision, the 10-year Treasury rate has come back down to approximately 2.50%. Read more »