How high are bond yields
likely to rise? That question has been on the mind of investors since rates
began to rise in earnest with Ben Bernanke’s comments in front of Congress in
late May. After starting the year at just over 1.75%, the yield on the US
10-year Treasury bond rose to just more than 2.05% in March before declining through
early May, reaching its low for the year at 1.63% on May 2nd. They
have been on an upward trajectory since, accelerating after Bernanke’s
testimony and reaching 2.88% on August 19th. Much of the rise in
yields has been due to concern that the Fed will taper its purchase of Treasury
and mortgage-backed securities as soon as next month and that it may end its
purchases as early as next spring. If the Fed does indeed taper its purchases
beginning next month, how high are yields likely to rise?
Using month-end data from
January 1970 through June of this year (two data points were unavailable, those
for March 1972 and May 1976), the spread, or yield difference, between 3-month
T-bills and 10-year Treasuries has only been greater than 4% on two occasions
and it has typically been around 1.50%. As this is being written, it is 2.78% (Chart 1). While the Fed is indeed likely to taper
its bond purchases in the immediate future and may even end them next year, the
probability of them raising their policy rate, currently at 0%, prior to the
end of next year is extremely low. We would suggest that it is unlikely prior
to 2015 and PIMCO has suggested it might not occur until 2016. As such, short-term
rates are likely to remain extremely low over the next two years. The widest
spread between 3-month T-bills and the 10-year bond occurred in the 3rd
quarter of 1982, as short rates plunged from record highs as Fed Chairman Paul
Volcker’s tightening campaign began to bring inflation under control (Chart 2). With the 3-month T-Bill currently at
0.05%, we can safely rule out a large decline in short rates that will push the
spread higher. That means to push the spread to 4%, we would need the yield on
the 10-year bond to rise just north of 4%. It’s hard to see what would push the
10-year yield north of 4%. Inflation remains well anchored as the velocity of
money is extremely low, with most of the money the Fed has printed remaining
deposited at the Fed in the form of excess bank reserves. More than 82% of the
US money supply was on deposit with the Fed as of the end of July. From January
of 1959 through the end of 2007, the average was just 6.18%. Economic growth
remains weak with the growth in each of the last three quarters below 2% on an
annualized basis. Importantly, even as the Fed tapers, declining budget
deficits will lead to reduced debt issuance and the Fed’s purchases are likely
to remain a relatively consistent percentage of issuance over the next six to
12 months. Finally, from 2004 through 2006, when the US economy was in
significantly better condition than it is currently, the average yield on the
10-year Treasury was just about 4.50%.