Picture this: It is 1609 and a new invention — the Dutch Telescope, a.k.a. the "spyglass" — is captivating audiences everywhere. Developed by eyeglass maker Hans Lippershy, this early refracting telescope was the first to use a convex objective lens with a concave eyepiece making objects very far away appear very close.
People went nuts over the new thing and its power to "trick" the mind. A year later, Galileo Galilei, the Italian scientific genius, got a hold of one and was one of the first people to do something so simple yet so extraordinary with it.
He turned it up towards the sky!
Everyone else was so focused on using it to see horizontally, but he thought creatively … and vertically. Soon he was obsessed looking at the moon and stars at night and thinking about his observations with a scientific mindset. The result was a revolution and the beginning of our modern understanding of astronomy.
A wide swath of financial media and their pundit agents have been thinking "horizontally" about interest rates for quite some time. The most common and short-sighted believed the Federal Reserve Bank was directly responsible for low yields on intermediate-term interest rates (think: the yield on the 10-year U.S. Treasury bond). The common argument went something like this: since the Fed was buying tons of bonds during their Quantitative Easing (QE) programs (recall bond math 101: buying pressure increases price and lowers yield), interest rates must be artificially suppressed lower.
That was not what happened when you studied the data. "Vertically" thinking folks (us included) noticed that intermediate-term bond yields went UP, not down, when the Fed conducted QE programs. Something else must have been going on.
The horizontal thinkers are using the opposite argument today — intermediate interest rates moved higher (the 10-year Treasury bond yield recently was 1.75% higher since mid-2016) only because the Fed has started to unload all those bonds it bought during their QE program.
Again, vertically-thinking folks are not buying the argument and use a better one: U.S. bond yields have been closely tracking economic momentum!
As economic momentum has gathered steam since mid-2016, bond yields have begun to move higher:
The rise in bond yields (shown in green above) since mid-2016 has tracked the rise in the Conference Board Leading Economic Index (shown in blue above) and economic growth. When the 10-year U.S. Treasury bond yield hit 1.36% during the summer of 2016, the U.S. was at the tail end of a two-year economic slowdown in which leading indicators sank and GDP growth decelerated.
However, as the Fed moved to the sidelines after stumbling out of the gate in December 2015 with its first interest rate hike in quite some time, credit markets eased and economic momentum accelerated. The LEI bottomed at -0.6% growth on a six-month annualized basis in the spring of 2016 just before bond yields bottomed and subsequently accelerated to a recent peak in March 2018 of 8.8%. Over this same period GDP growth improved. This acceleration of GDP growth can fully explain the 1.75% rise in the 10-year Treasury yield over the same period.
Thus, where we go from here (on yields) rests critically on where economic momentum heads. Leading indicators are now probably peaking and will continue to ease back toward the economic recovery averages since 2010. Similarly, GDP growth will likely slow over the next year or two as the Fed raises interest rates and brings growth back into line with the economic growth potential of the U.S. economy, i.e., GDP growth of around 2% on a year-over-year basis. Hence, bond yields may have peaked for now.
Contact Russell Moenich to learn more about this topic.
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