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The increase in the US 10-year bond yield from its historical post-WW2 low point of a tad under ½% during the peak of the Covid crises back in mid-2020, to its current rate of around 4.5% (a level last seen about 16 years ago prior to the GFC) is nothing short of remarkable. Especially so, when you consider the yield on the US 10-year bond yield for the 14-odd years following the GFC averaged just 2.6%, prompting the “lower-for-longer” narrative that dominated financial market thinking until 2022.
While bond yields had been steadily climbing from their pandemic low points of 2020, yields took a sharp leg up following the outbreak of the Ukraine/Russia war and subsequent inflation surge, temporarily breaching 4% over the December quarter of 2022. Over 2023, until August, US bond yields appeared to stabilise, trading in a range between 3.5% and 4%, at an average of 3.7%.
A rate of 3.7%, while high relative to the decade from 2012 to 2022, it is not high compared to rates prior to the GFC. The post-GFC period was characterised by quantitative easing (QE) being implemented by almost all developed countries’ central banks. The impact of QE showed up in central bank policy rates being set and held at their lower bounds (typically 15 basis points either side of zero) for the large part of this period.
The shift in policy approach was successful in stabilising inflation expectations in the post-GFC decade as the economy faced headwinds to growth and inflation from (1) governments unwinding the enormous build up in public debt and (2) the exportation of low prices globally as China and other developing countries absorbed excess productive capacity through export-oriented economic policies. The stabilisation of inflation expectations consistent with the Fed’s target rate of inflation (2% in terms of the PCE deflator) over the post-GFC decade is a crowning achievement of the QE policy regime, particularly given unprecedented weakness in inflation: US core PCE inflation averaged just 1.6% from 2009 to 2021.
Low nominal rates combined with target-level inflation expectations resulted in extremely low real interest rates over the post-GFC decade, with US 10-year real yields (as measured by TIPS) averaging just 0.2% over 2009-2021 and with yields turning negative throughout 2020, 2021 and into the June quarter of 2022. The suppression of interest rates by central banks’ adoption of QE also had the effect of driving an unprecedented wedge between national income growth and interest rates.
In the period between 2009 and 2022, nominal income growth of the US economy (as measured by nominal GDP) averaged a trend-like rate of 4.1%, while the fed funds rate averaged just 0.5%; a differential in favour of income growth of 3.6 percentage points (ppts). Since the start of the 1970s, there is only one other period where interest rates sustained a significantly lower rate than income growth and that was between 2002 and 2007 when a Greenspan-led Fed held rates at 1% while awaiting a (delayed) recovery in employment from the recession that followed the bursting of the Dotcom equity price bubble.
Outside of these two episodes, the differential between nominal income growth in the economy and interest rates is negligible. Extraordinarily low real interest rates and a sizeable wedge between income growth and interest rates combined to drive extended global price rallies across risk assets including equities and housing, with low interest rates providing the catalyst and the gap between income growth and interest rates lowering the effective debt-servicing burden.
However, following the Ukraine/Russia war, real yields have backed up in the US from around -1% to their current level of around 2.2%; taking us back to a pre-GFC era. What can be said about the reaction of the economy and risk assets to the sharp rise in real yields?
One would have to admit that both the economy and asset prices have remained resilient to the rise of interest rates since exiting Covid. The US economy grew at a trend (1.9%) over 2022 and looks to be heading for an above trend rate of growth of slightly more than 2% this year.
The US equity market has reversed out some of its post-Covid gains (down by around 10%) from its end-2021 high point, but the anticipated bear market expected by many commentators has failed to materialise. So, where to from here?
As we exit Covid, however, we are also exiting the post-GFC era where global interest rates were suppressed by a combination of QE and low goods-price inflation due to export-oriented growth policies of China. This should lead to a reinstatement of a more normal relationship between interest rates and a countries rate of growth in income.
As inflation expectations are close to central bank target rates, we can expect real yields to remain at levels close to the real long-run potential growth rates in the economy. In the US, we estimate this to be somewhere around 1½%. Although this is lower than current marketing pricing of around 2.2%, it is certainly higher than 0-½%, as implied by the current Fed’s forward guidance contained in September’s Summary of Economic Projections.