The 10-year U.S. Treasury bond yield peaked at 3.24% last year on November 8 (Fig. 1). When the yield first rose above 3% in the previous May, there was lots of chatter about how the 10-year was likely to rise to 4% and even 5%. Those forecasts were based on the widespread perception that President Donald Trump’s tax cuts would boost economic growth, inflation, and the federal deficits.
In addition, the Fed had started to taper its balance sheet during October 2017, and was on track to pare its holdings of Treasurys and mortgage-related securities by $50 billion per month (Fig. 2). It was also widely expected that the Fed would hike the federal funds rate four times in 2018, which is what happened, and that the rate-hiking would continue in 2019 into 2020.
Furthermore, the Bond Vigilante model, which correlates the bond yield with the year-over-year growth in nominal GDP, was bearish since the latter rose to 5.5% during the third quarter of 2018. (Fig. 3). But instead of moving higher toward 5.5%, the 10-year yield fell back below 3%.
What gives? The Dow Vigilantes screamed “no mas” at the Fed during the last three months of 2018, allowing the Bond Vigilantes to take another siesta. The Fed got the message, and the word “gradual” was first replaced with the word “patient” to describe the pace of monetary normalization by Fed Chairman Jerome Powell on January 4. The two-year Treasury yield, which tends to reflect the market’s year-ahead forecast for the federal funds rate, dropped down to that rate (at 2.38%, the midpoint of the 2.25%-2.50% range) last January 3 (Fig. 4) and (Fig. 5).
Last year, I surmised that the bond yield might be “tethered” to the near-zero yields for comparable JGBs in Japan and Bunds in Germany (Fig. 6). I also argued that based on 40 years of experience in the investment business, I’ve never found that supply-vs.-demand analysis helped much in forecasting bond yields. It’s always been about actual inflation, expected inflation, and how the Fed was likely to respond to both. The most recent bond rally was mostly driven by a drop in the expected inflation rate embodied in the yield spread between the 10-year Treasury and the comparable TIPS (Fig. 7). The spread dropped 30 basis points since October 9, 2018 through Wednesday of last week.
Meanwhile, the Treasury yield curve remains flat, with the yield spread between the 10-year bond and the federal funds rate at just 36 basis points as of late last week (Fig. 8). This suggests that Powell & Co. may pause rate-hiking for as long as the yield curve spread remains this close to zero. If they raise rates, they risk inverting the yield curve. That might stir up the Dow Vigilantes again.
Do federal deficits matter to the bond market? Apparently not. Remember, it’s all about inflation. If deficits boost inflation, then they will matter.
Ed Yardeni is president of Yardeni Research, Inc., a provider of global investment strategy and asset allocation analyses and recommendations. He is the author of Predicting the Markets: A Professional Autobiography. Institutional investors may sign-up for a four-week complimentary trial to his research service at https://www.yardeni.com/trial-registration/
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