My analysis of post-World War II history reveals that a 100 basis point rise in the funds rate is associated with a 36 basis point rise in the 10-year Treasury yield and a increase of 24 basis points in the Yield on 30-year Treasury bills. The further out the yield curve, the less influence central bank policy has.
The 10-year bond yield peaked at 3.48% on June 14, the highest since 2011. It has since fallen back to around 3.22%. The yield jumped 2.18% on March 16, when the Fed first raised its benchmark rate from a range of zero to 0.25% to a range of 0.25% to 0.5% (it is now in a range of 1.5% to 1.75%). The 1.30 percentage point jump in the 10-year rate implies a 3.5 percentage point rise in the funds rate, bringing it closer to 4%. That’s high enough to kill the economic expansion that floated on a sea of readily available and cheap credit.
In response to the 2008 financial crisis, the Fed introduced quantitative easing, which increased its assets from $900 billion to $4.5 trillion. Then, with the pandemic, central bank assets nearly doubled to $8.9 trillion this month. Most of all this money has been invested in residential housing as well as stocks and many speculative financial assets. Ditto for the $3.75 trillion provided by the government in response to the pandemic. The shift from central bank money tsunami to Fed treasury cuts via quantitative tightening and the end of massive fiscal stimulus is a major shock to the economy. The recession will dampen credit demand and heighten the zeal for safe havens, all to the benefit of Treasuries. Additionally, the strength of the dollar makes US government securities attractive to foreigners, as does the fact that the 10-year Treasury note has a higher yield than sovereign debt in 13 out of 18 developed countries. In recent economic cycles, the yield on 10-year Treasury bills has peaked before the onset of a recession. It peaked at 6.7% in June 2000, before the 2001 recession. Similarly, it peaked at 5.1% in June 2006, 18 months before the start of the 2007-2009 recession.
A similar track could happen this year. Retailers are chopping orders in response to excessive inventory after mistakenly anticipating huge holiday sales at the end of 2021 to US consumers who were already saturated with merchandise. Since then, consumers have decided to spend money on services such as restaurants and travel. About 0.8 percentage points of the 1.4% decline in real gross domestic product in the first quarter was due to inventory reductions and more will follow as goods from Asia that are unloaded at ports from the west coast are routed inland. The backlog of ships at the ports of Los Angeles and Long Beach fell from 109 in January to 30 in May.
Consumers will likely continue to refrain from purchasing goods. Inflation-adjusted retail sales fell in May for the 14th consecutive month. Even nominal sales fell in May. Real hourly wages have been falling for more than a year, and the University of Michigan’s consumer confidence index plunged to an all-time low in June in data dating back to the late 1970s. Home sales existing homes fell in May for the fourth straight month and fell 8.6% from a year earlier as mortgage rates rose and homes became the least affordable since July 2007, according to the National Association of Realtors.
Inflation may also have peaked. The consumer price index rose 1.2% in March from the previous month and returned to gains of 0.3% in April and 1% in May. Similarly, the producer price index rose 0.8% in May, down from the 1.6% increase recorded in March. The Fed often switches from credit crunch to easing once it sees it has done the act of recession. This was the case of the recessions of 1960-1961, 1969-1970, 1981-1982, 1990-1991 and 2001.
However, while battling the severe inflation of the early 1970s, the central bank did not move from tight credit to looser terms until July 1974, even though the peak of the business cycle was in November 1973. Fed now desperately trying to get ahead of the inflation cycle, it may not reverse gear until the recession is well underway.
Of course, no one rings the bell when an economic downturn begins. With all the late reports of data and revisions, it’s often months or quarters after its launch that the National Bureau of Economic Research, the acknowledged arbiter of recession dating, identifies the peak of activity, and often not before the next dip. If I’m right that treasury bond yields will fall as inflation rates fall, then treasury bond prices will rise.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Gary Shilling is president of A. Gary Shilling & Co., a consulting firm. He is the author, most recently, of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation,” and he may have an interest in the areas he writes about.
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