Investors have been in a funk as the yield on the 10-year Treasury note approached, then briefly exceeded, 3% last week.
Pundits proclaimed the end of the 35-year-plus bull market in bonds, the beginning of a new era of inflation, even a major inflection point for the Dow Jones Industrial Average DJIA, -0.85% and the S&P 500 SPX, -0.29%
But what if, unlikely as it sounds, 3% is near the peak of where the 10-year Treasury TMUBMUSD10Y, +0.41% will go this cycle, rather than the start of a new, secular upward move in yields?
That’s exactly what Kathy Jones, chief fixed-income strategist for the Schwab Center for Financial Research, argues. In fact, she doesn’t think rates will head much higher than 3% over the next few years.
Remember, the 10-year yield topped 3% briefly in late December 2013, only to plummet to 1.37% in July 2016. It’s since risen sharply from that all-time low.
And Jones points out there’s ample historical precedent to back up her contrarian claim.
This chart shows that in three of the last four market cycles, 10-year Treasury yields peaked right around where the federal-funds rate did.
In 1988, the 10-year note hit a top yield of 9.4%, just below the 9.8% peak fed-funds rate. The same thing happened in 2000, when both fed funds and the 10-year Treasury topped out just below 7%. And in 2007, just before the financial crisis kicked into high gear, fed funds and the 10-year hit their high-water mark around 5 1/4%.
Only in 1994-95, when Alan Greenspan’s Federal Reserve doubled the fed-funds rate in only a year, did the 10-year Treasury’s peak exceed that of fed funds — 8% vs. 6%.
There’s a pretty simple reason these two rates move in tandem, which goes back to Finance 101, Jones told me in a telephone interview last week.
“Long-term rates should reflect the weighted average of short-term rates plus a risk rating,” she said.
The main risk of holding longer-term bonds, of course, is inflation. When that threat appears, investors sell longer-term bonds, causing prices to drop and yields to rise.
But “as short term rates move up,..the expectation is that by raising those rates, you are going to slow the economy and cool off inflation,” said Jones. Short and long rates should come pretty close together “when the market perceives that we’ve got the monetary policy that will…get us back to this equilibrium level where inflation is not going to accelerate,” she explained.
That’s where we’re heading now, she said. As this column has argued, inflation still hasn’t reared its head, but the fear of it hasn’t abated. “For years and years and years, people’s future expectation for inflation was 3%. Now it’s more like 2 1/2,” said Jones. On Monday, the personal-consumption expenditures (PCE) price index rose by an annual 2%, hitting the Fed’s inflation target for the first time in a year.
The prospect of muted inflation, even as GDP growth improves, is why Federal Reserve Board members and Federal Reserve Bank presidents aren’t looking for a much higher fed-funds rate in coming years. As of the March rate-setting meeting, those Fed officials project PCE inflation of 2.1% and a fed-funds rate of 3.4% by 2020.
If events follow history — and there’s no guarantee they will — the yield on the 10-year Treasury won’t go much higher. “I don’t think that we’re in a trajectory that will get us anywhere close to where we were in 2007, in terms of yields,” said Jones. “Could the market let 10-year yields bounce between 2 1/2% and 3 1/2% for a very long period of time? Sure. That’s a very reasonable outcome over the next five years.”
A 3 1/2% peak yield? Over the next five years? That would surely disappoint the professional panic-mongers, but I can’t see much down side for the rest of us, who would finally, finally earn half-decent income from good old short- and intermediate-term bonds.
Howard R. Gold is a MarketWatch columnist and founder and editor of GoldenEgg Investing, which offers exclusive market commentary and simple, low-cost, low-risk retirement investing plans. Follow him on Twitter @howardrgold.
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