how much higher will rates go?
It seems to me to be hard to deny that the process of normalizing (read: raising) interest rates in the US from their emergency-low levels has begun. The 10-year Treasury bond–the security that has the most influence over the determination of the stock market PE ratio–was yielding 1.72% in early April. Last Friday the yield was 2.52%, a rise of 80 basis points. The 30-year has moved up by 77 basis points over the same time span–from a yield of 2.88% to 3.65%.
If we look at the price of overnight money (the Fed Funds rate), which is the usual tool the Fed uses to influence interest rates, it’s still at effectively zero. This rate is completely under the Fed’s control. The Fed says “normal” is 4% or so, and that it won’t make any move away from zero until the unemployment rate is below 7%.
The Fed has also been trying to push down longer-term interest rates, particularly the rate for mortgages, through unconventional means–buying tons of these securities in the open market. The Fed has recently hinted that, although it will continue to do so, it may begin to purchase less than the current $85 billion a month as the economy shows further strength. This could happen as soon as the fall. That’s why the yields on the 10-year and the 30-year have been rising.
What’s normal for them?
three simple guideposts
1. Look back to mid-2007, when the financial crisis was just beginning to unfold and see what rates were then.
The 10-year was yielding 5.03% at the end of June 2007; the 30-year was yielding 5.12%.
To get back to those levels, the 10-year would have to rise by another 250 basis points, the 30-year by 150 bp.
2. Take the rule of thumb that the 10-year should provide inflation protection plus a 3% real yield. The Fed’s inflation target is 2%, implying that in a normal economy the 10-year would yield around 5%.
3. The Fed is going to eventually raise the rate on overnight money by 4%. Longer-term rates will rise by less, because they fell by less when the Fed Funds rate was going down.
Inflation is currently significantly below 2%, implying maybe a 4.5% 10-year yield.
Chinese buying has arguably depressed Treasury yields over the past decade or so. Will that continue? (My answer: probably not.)
As the Baby Boom ages, it becomes more income oriented. That may keep rates lower.
…which may end up cancelling one another out
My experience is that the simplest models are most often the most accurate ones. In addition, whether the ultimate 10-year yield is 4.0% (unlikely, in my view) or 4.5% or 5.0% doesn’t matter at this point. There’s still a long way to go.
I think the bond market has taken a surprisingly strong first step toward interest rate normalization.
Looking at the stock market PE, it seems to me that equities are already priced for a world where the 10-year is yielding 5%+–and have been for the past several years.
As for my portfolio, I’m waiting to see signs that the stock market is stabilizing so I can buy stocks that have been excessively pummeled during the current slide.