What Just Happened in the Treasury Market Has Only Occurred Once Before
The interest rate on the 10-year treasury has done something that has only occurred one other time in the history of the series (dating back to the 1950s), it has managed to rise above the fed funds rate peak from the previous rate hiking cycle, in this case the cycle that ended more than 3 years ago.
This is a rare occurrence and only happened one other time, back in the mid 1990s (pictured below).
So are bond yields headed for a permanent breakout to the upside? In order to answer that question let’s look at a couple factors.
Labor Force Participation Rate
The labor force participation rate has been in terminal decline since its peak in the late 1990s, the sharpest decline occurring after the Great Financial Crisis in 2008. We have now returned to a level we haven’t seen since the 1970s when women were just starting to enter the workforce.
With social movements such as “the great resignation” growing in popularity it appears that the younger demographic intends to work less, not more. An increasingly disinterested and absent labor force does not lead to economic growth, just the opposite. Without economic growth, higher interest rates cannot be supported.
Federal debt/GDP has skyrocketed since the GFC. As the size of government increases, growth in the private sector decreases. This is caused by the crowding out effect whereby resources that would ordinarily go toward private investment are diverted in order to service the increases in federal debt. The long term consequences of increases in the debt are always a decrease in bond yields. Inversely, interest rates have a tendency to rise when debt remains low or declines.
A declining birth rate is a product of a decline in economic activity. As people have fewer and fewer children, tax receipts decline. In order to fight this, governments must continually increase debt issuance. As we saw in the previous section this action by the government tends to have a crowding out effect and interest rates fall. Don’t believe me? Have a look at countries with awful demographics and high debt, countries such as: Germany, Italy, Japan, and South Korea. In each case interest rates have been in terminal decline for years if not decades. The U.S. is on the same path.
Where Do We Go From Here?
What we are currently witnessing in the bond market is merely a blowoff top. Rates are rising as consumers, governments, and central banks fret about inflation. However, we have been here before. It is truly amazing how quickly people forget what happened in the 4th quarter of 2018. While Jamie Dimon was calling for 4% interest rates on the 10-year treasury, the market turned sour and in less than a year interest rates on the 10-year had declined to 1.5%...a far cry from Dimon’s prediction. The real kicker here is the fact that inflation and growth expectations in 2018 were far superior to what they are today. There were no Covid or supply chain issues and even the debt situation was significantly better (albeit still terrible overall). Even in that more positive environment, the 10-year treasury only managed to reach 3.2%.
What if we go further back…to the only other time the 10-year treasury managed to invert the previous cycles fed funds rate peak? What happened back then? Despite the 1990s being economically superior to today in every conceivable way, the 10-year still reversed course in short order, continuing on the same downward trajectory from which it has yet to escape.
As the 10-year treasury inches closer to 3%, will it soon reach escape velocity? Or, will the gravitational pull of poor growth, high debt, and bad demographics bring it back down to earth? You be the judge.
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