An End To The Conundrum?

The trend in long-term Treasury yields looks to be decidedly upward -- from daily lows under 4.4 percent in late December and January, ten-year yields closed yesterday at just over 4.7 percent -- and the buzz that there is more, maybe much more, to come is in the air.

The first response to this should probably be caution. Ten-year yields were peaking near 6-1/2 4-1/2 percent about this time last year -- by June they were under 4 percent.  In June 2004 the yield had reached 4.8 -- by September that year they were back to 4.  So there is plenty of precedent for another reversal. (Kash has the picture.)

But suppose, just for the sake of argument, that we are seeing a return to interest rates comparable to the levels of, say, the latter half of the 1990s (1995-2000), when the 10-year yield averaged just a bit over 6 percent.  A couple of hypotheses as to why the time has come:

-- The global economic outlook for most of the industrialized world has turned at least baby bullish.  Japan looks to have finally turned the corner, the view from the EU is optimistic, and, if you are the optimistic sort, most of the news since the beginning of the year has suggested that the weak performance of the U.S. economy in the fourth quarter of 2005 was more of an aberration than the beginning of a trend.  (Take this week's manufacturing, inventories, and orders report for January. If you are an optimist, you can point out that things were not as bad as expected, and that orders outside of the volatile transportation sector continued to grow.)

To be sure, there are those that suggest consuming the positive with a grain of salt, and those that are downright skeptics.  But that is not really the point here.  If a broad-based acceleration of economic activity is in motion, then we would expect to see upward pressure on long-term rates, and we would expect those higher rates to finally stick.

-- There is another possibility: Monetary policy in the US (and maybe elsewhere) has finally turned restrictive, and that is beginning to show through to long-term rates.  The most basic story of the term structure is the so-called expectations theory of the yield curve.  The idea is simple: Long-term rates reflect the average of the sequence of short-term rates expected to prevail over the period until a given long long-term security matures.   Back when the federal funds rate was 1 percent, nobody expected that they would stay there forever. Indeed, when the rate hikes commenced in June 2004, members of the Federal Open Market Committee were forthright in expressing the opinion  that there would be many more to come.   

Up until recently, then, you might argue that increases in the funds rate were merely validating expectations.  But now that the market anticipates a funds rate up to (at least) the top end of what was often offered as the neutral range -- a belief reinforced in no small measure by indications from the Committee that slightly restrictive may be preferable to strictly neutral -- the new view is simply being priced into long-term bonds.

--- There is a lot of commentary about the unwinding of the so-called carry trade, but these bond market tales always strike me as a bit of the tail wagging the dog.  I have no doubt that it describes what motivates traders -- but unless the fundamentals back the play, there are baths to be had.  In the end, I'd guess the carry trade explanation is consistent with either of the above stories.

As for me, I'm not sure which of these explanations to go with at the moment (and that includes the one that proposes it's all a temporary blip). But I'm still of the opinion that the Bernanke global savings-glut/investment-dearth story was right on target. The basic conditions Mr. Bernanke was alluding to have not, in my estimation, gone away.  And that ought to at least put a ceiling on how high rates will go.

UPDATE: Professor Hamilton shares his thoughts, and links to posts at William Polley and at Economist's View that I should have.