Yields on 10-year Treasury notes have spent 18 sessions trading above 4% this year, but some doomsayers are ready to declare a permanent shift to a higher-yield regime. They attribute it to factors such as demographics, the looming clean-energy transition and large government deficits. And sure, that could be.
But there’s a glass-half-full interpretation that may have been lost in the histrionics: Perhaps the jump in longer-term yields is just what the Federal Reserve needs to complete the proverbial last mile in its inflation fight — a necessary but ultimately temporary part of the disinflation process. And perhaps the question isn’t “Why is this happening now?” but “Why didn’t it happen before?”
Consider a two-part series of blog posts written by Minneapolis Fed President Neel Kashkari a little more than a year ago titled “Policy Has Tightened a Lot. Is It Enough?” To assess how much tightening would be sufficient, Kashkari floated the idea that we should focus on real longer-term Treasury yields (not nominal overnight rates) because they feed directly into products such as residential mortgages and business loans.
In a historical example from the 1990s, Kashkari found that the 10-year real yield had to rise about 200 points above “neutral” to get a lid on inflation. Kashkari seemed to think that real 10-year yields in the current episode might have to get to around 2% or higher to match the level of restrictiveness in the 1994-1995 tightening campaign. Here’s the salient passage from the June 2022 post (the second part of the series, emphasis mine):
It seems as though policy drove the 10-year real rate about 200 basis points above neutral. ... The underlying inflationary dynamics are quite different today than in 1994, so simply repeating the 1994 tightening might not be enough. We have done about half as much real tightening as in 1994, and we might need to do more.
I bring all this up because we’ve finally reached the 2% milestone that Kashkari flagged in his post about 14 months ago. Real 10-year yields have climbed about 52 basis points in the past month and (at the time of writing on Monday) now stand at 2% on the nose. If you accept the general logic from Kashkari’s post, then the yield curve may just now be starting to apply the kind of restraint that was required in previous episodes to subdue economic activity and cool inflation. That might help explain why the economy had been merrily humming along, with many sectors unbothered by the rate increases. On a seasonally adjusted annualized basis, real gross domestic product growth exceeded its potential in the second quarter and may be set for even faster expansion in the third.
Admittedly, I’m glossing over some factors relevant to the complex debate about what constitutes “sufficiently restrictive” monetary policy and financial conditions. Those include, on the dovish side, the nature of inflation in the current episode (some would say that supply-chain-driven inflation always called for less “restraint”) and, on the hawkish side, the analysis of what constitutes the “neutral” long-term rate of interest (in his analysis, Kashkari put it around zero before the pandemic, but many people now think it’s higher than that — and maybe significantly so). But on the net, the move up in longer-term bond yields might actually be a positive, appropriate and temporary development for the inflationary challenge at hand.
So why did it take so long for 10-year yields to rise? My best guess is that a critical mass of investors and traders either still thought that inflation was transitory or that the global economy was heading into a recession. There were also unique supply and demand dynamics at play, which finally started to come undone when the Bank of Japan started tiptoeing away from its yield curve control policy last month and the Treasury increased the size of its quarterly auctions.
Now, of course, tighter policy is reaching the rest of the yield curve. As a result, 30-year mortgage rates are soaring (on both real and nominal bases), as are all-in borrowing costs on corporate debt. Some will say it’s “too much, too late,” and that’s possible, too. Inflation had already been coming down somewhat gracefully in a series of official government reports, thanks to supply-chain normalization, among other things. To some ultra-dovish observers, the recent CPI reports have challenged long-held notions that economic restraint and weaker labor markets were ever necessary to achieve full disinflation. But as various sectors of the economy have heated back up, it’s become harder to imagine that inflation would fall all the way back to the Fed’s 2% target without an extra nudge from financial conditions.
Not everyone sees the developments in the same light. Economist Ed Yardeni — who coined the term “bond vigilantes” in the 1980s to refer to investors who protest government policy by driving up yields — suggested that the vigilantes were “saddling up” again in response to US deficits and that Fed officials would probably use remarks at the Kansas City Fed’s annual symposium in Jackson Hole this week to bring yields back down. “They can’t really afford to see this bond yield keep going up, so they’ve got to calm the bond market down,” Yardeni told Bloomberg Surveillance on Friday. But I suspect there may be members of the Fed’s rate-setting committee who could be inclined to see bond traders as friends — not some rogue, vigilante foes — and will happily let market trends play themselves out. After all, history suggests this is all a normal part of the disinflation process; it’s just happening a bit later than you would have otherwise expected.
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