Today the yield on the ten year Treasury went up 0.12%, about three or four times the typical day’s movement.
Reasons for yields to go up are that the economy is growing and experiencing rising wages and a shrinking jobless rate. Based on old cliché-like paradigms of the pre-2008 crash era the ten year bond yield should be the sum of inflation and GDP growth, about 4.5% total (today it’s 3.18%). Also, the real yield should be about 2% (1% higher than today) which means, if inflation is 2.2%, then nominal yields should be 4.2%. So based on old-style fundamentals the ten year Treasury could go to a range of 4.2 to 4.5%.
The effect of bond yields rising roughly 1% higher for the ten year Note to about 4.2% would be that the bond’s price would go down about 9%. If one owns a four year duration bond portfolio they might see bond prices drop 4%, but they would be able to reinvest bond coupons (payments) and thus get a higher rate of return over several years.
However these old fundamentals should be replaced by new fundamentals: The old ones are based on a solely domestic economy; a newer fundamental view incorporates the global economy, which is far weaker and more prone to disinflation and crashes than the U.S. The new fundamental view (since 2008) is that many foreign countries have excessive government subsidies to produce goods for export, thus these goods tamp down inflation. These industries, created and nurtured by subsidies, are addicted to operating at a loss, if need be, so as to create jobs. They are stuck in a zombie economy of trying to stay in business even if they lose money. This is disinflationary. Thus in recent decades the global economy has gradually established a new paradigm of too many loss-leading manufacturers who act to oversupply the economy which reduces global inflation and interest rates. The new future source of disinflation will be the cooling down of China’s economy, resulting in less opportunities for the world economy to export construction materials to China. As China copes with trade wars and other problems they will devalue which will undermine Japan’s economy, leading to competitive devaluations between Japan, China and the EU. Italy is at risk of breaking away from the EU or wrecking the finances of the EU by defying EU budget rules; this could lead to a disinflationary crisis. Since Japan and the EU have negative interest rates, if they devalue then that will act to spur their citizens to export funds to the U.S. to buy our bonds, thus lowering our interest rates. Currently they are reluctant to do so because fear the U.S. dollar will be devalued, but I believe it is other nations that will devalue, and when it happens there will be a flood of capital into the U.S., resulting in lower yields.
The dominant global economic paradigm in recent decades is corporate cost cutting by using globalization, which is used to obtain ever-lower wages for corporations which acts to reduce inflation and reduce worker’s purchasing power, which is also disinflationary. Trump’s conclusion two days ago of the renegotiation of NAFTA resulted in only minimal changes, thus the disinflationary problem of good paying jobs leaving the U.S. hasn’t been solved. I believe globalization will continue to grow, thus reducing wages for people in Developed countries, including a newer phenomenon of affecting many white-collar occupations. In some poor countries white-collar managerial wages are $1 an hour, so the huge gravitational tug of cutting managerial wages from $50 an hour in the U.S. to $1 offshore act as a powerful force, more fundamentally reliable than the cavalier, naïve actions of bearish bond futures speculators who assume we will go back to the old high rate paradigm that yields ought to be the sum of inflation and GDP. The growth of employment in the U.S. has been miscounted because people with shaky commissioned or tippable “jobs” are counted as employed even if they are significantly under-employed. Also the excessive volatility of earned income for some workers who work on a contingent basis means they effectively have less income than was promised because they can’t afford to rely on their full paycheck since they need to discount the risk of a reduction in billable hours.
The old paradigm was that a reduction in unemployment means workers can get loans which expands the money supply and causes inflation. But bankers won’t fooled by today’s shaky pseudo-jobs that don’t meet loan qualification rules. If a worker can’t access “A” paper credit then a newly employed worker can’t cause inflation.
Since 1996 the debt to GDP ratio has doubled. When people have excessive debt they have to reduce their spending. As more people become debt slaves then less spending will occur, which is disinflationary. As yields increase some debtors will crack under the pressure of rising interest rates and will go bankrupt which is deflationary.
Rising yields will hurt the ability of the VIX market to offer low cost put options (assuming that a misguided search for yield in puts is tied to bond yields) thus inducing stock market speculators to sell some of their stocks. Once a big stock crash occurs this will magnetically attract a lot of capital to bonds, forcing down interest rates. If stocks crash 22% in a day as they did in 1987 then a margin loan using speculator could lose 44% in a day which will motivate others to cut back on inflationary consumption.
One reason yields went up a lot today is because speculators can pile on to a trade in the futures market and create a momentum trade, a sort of bubble, in this case, a mistake where the market incorrectly assumed inflation is returning.
Investors need independent financial advice about bond market risks.