U.S. investment grade bond yields have risen considerably in recent weeks, an extension of the move that started in early July 2016. For example, the yield on the 10-year Treasury note was 1.37% on July 8, 2016, had risen to 1.86% at the end of October, and has now shot up to as high as 2.40% intraday in late November. We are currently just shy of the multi-year highs of 2.50% set in June 2015.
The fundamental rationale for the more recent increase in bond market yields is fairly straightforward. Investors perceive that the largely unanticipated rise of President-elect Donald Trump is likely to usher in a reduction of burdensome government regulation of the private sector economy, in addition to increased fiscal stimulus through infrastructure-focused deficit spending, which will reduce pressure on the Federal Reserve to maintain extraordinary levels of monetary accommodation.
Rising bond yields are also understandable from the perspective of real inflation-adjusted returns. Core inflation, as measured by the core personal consumption expenditures (PCE) deflator – the Fed’s favored gauge of inflation – has held steady at 1.6% to 1.7% for the entirety of 2016. The yield on the 10-year Treasury note has now moved significantly back into positive inflation-adjusted territory in the aftermath of the U.S. presidential election. From this perspective, the U.S. election results have let some of the air out of the negative inflation-adjusted U.S. investment grade bond market bubble.
Stock market investors have largely taken the period of rising bond market yields in stride. The increase in 10-year T-note yields from 1.37% at mid-year 2016, to as high as 2.40% presently, has seen the S&P 500 equity index ascend to over 2,200 from 2,130 over the identical timespan. Rising interest rates have recently weighed on the performance of high yield bonds that are now underperforming the broad equity market year-to-date but are outperforming investment grade bonds. In the absence of evidence of accelerating GDP growth and escalating consumer price inflation, the Fed is likely to retain its overall measured approach to normalizing monetary policy, which should not be too disruptive to investors’ appetite for relatively riskier financial assets such as stocks and high yield bonds.
This brings us to the question of how high might bond market yields rise? Sustained moderate two-to-three percent U.S. GDP growth in an environment of sub-two percent core PCE deflator inflation could see 10-year T-note yields capped for the time being at 2.50%. Any deviation from existing economic conditions would have to be evaluated within the context of longstanding Fed, and potentially now Federal government legislative efforts, to fully extricate the U.S. economy from the deflationary pressures that emerged in the aftermath of the financial crisis and recession back in 2009.
In a dramatically different secular inflation expectations environment, recent years have seen the yield on the 10-year T-note move significantly below the dividend yield associated with the S&P 500 equity index. Even now, the 2.40% yield on the T-note is only marginally above the dividend yield at approximately 2.1%. Prior to the events leading up to the “Great Recession,” the 10-year T-note yield consistently held at least two percent higher than the dividend yield of the stock market. A return to a fully historical normal set of financial market conditions, as opposed to the “New Normal,” would apparently argue for high quality bond market yields that are considerably higher than existing levels, regardless of the recent sharp increase in yields.
SPIAS remains vigilant in our surveillance of the U.S. and global economy for developments that could upset the existing equilibrium state resulting in sustained moderate economic growth, low inflation, and respectable expected forward looking corporate earnings growth.
Article by S&P Global Market Intelligence
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