Why The Swoon In The 10-Year Treasury Yield Is Temporary


The benchmark 10-year Treasury note recently flirted with the 3% yield level, but has fallen back again to around 2.8%, thanks to the Italy crisis. As usually happens when trouble stirs anywhere important in the world, investors flocked to the safety of the 10-year, which boosts its price – and pushes down its yield (the two move in opposite directions).

So what’s coming next? Odds are, after this latest European contretemps, the 10-year’s yield will resume its climb.

Up until the Italian imbroglio, bond volatility – as measured by the Bank of America/Merrill Lynch MOVE index – neared its lowest level in the past two decades. That was owing to upward synchronization of economics around the world and tame inflation. Then came Italy.

The placid market for the 10-year has been disrupted by the Italian mess: The country can’t form a government after the victory of far-right and far-left parties in its recent election. Populist sentiment in Italy, signaled by the voting results, may lead to the country’s withdrawal from the European Union (a la Britain) and the continent’s monetary union. The departure of Europe’s third largest economy would leave a big gap, and would have reverberations far and wide.

But that’s not the only factor that has prompted a buying rush for the 10-year. Several U.S. indicators have come in rather weak, notably the first quarter gross domestic product increase, a mere 2.3% as consumers tempered their purchases. And there’s fear that the Federal Reserve will step up the pace of its tightening regimen, boosting short-term rates to the point that it threatens the economic expansion. That unease clobbered the stock market in February and stocks have bumped along sideways since.

The 10-year, which is important because mortgage rates and many corporate bond yields track it, has had quite a ride. When the financial crisis hit in September 2008, it sat at 3.8%, and tumbled all the way to 1.3% in mid-2016, the low point for this century, due to the slow recovery. Then, as the economic tempo quickened and inflation nudged up, the yield began ascending, reaching 2.2% 12 months ago and hitting the recent peak of 3.1% in mid-May.

There’s an argument that around 3% is a natural ceiling for this storied bond. Seems that every time this Treasury tries to rise toward the pre-crisis level, some cataclysm intervenes, with investors scrambling to own the 10-year and its perceived risk-less nature.

The wise souls at the Jerome Levy Forecasting Center beg to differ. In its most recent report Srinivas Thiruvadanthai, Levy’s director of research, argued that ample evidence exists of a robust continuing expansion. Climbing purchasing managers indexes, freight shipment, production and imports demonstrate this well, he contended.

What’s more, Thiruvadanthai went on, the economy can count on the stimulus from added federal spending, to the tune of about $150 billion this calendar year. The tax cuts and the removal of spending caps have kicked the stimulus into gear. “Stronger than expected growth is likely to push yields higher along the curve,” he wrote, with the longer-term Treasury bonds climbing the most.

Of course, the yield curve – which plots the yields of the shortest to the longest maturity bonds – could flatten, or even invert. With an inverted curve, short-term maturities yield more than long ones. And that is a harbinger of a coming recession, although not always. At the moment, the distance between the two-year Treasury and the 10-year, called the spread, is rather tight, at around 0.4 percentage point.

Yet despite its status as the ultimate haven for spooked investors, the 10-year won’t remain  need to keep vacuuming up panicked investments forever. Europe managed to stumble through the woes of Greece, Spain and Portugal at the beginning of the decade. And whatever Italy does, and it’s far from sure that it will secede from the rest of Europe, the continent’s banks are a lot stronger than they were in the past.

Who knows? Maybe the 10-year will make its way to 4%.

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