Why are other yields falling as Treasury yields rise?

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This post is a guest contribution by Paul Kasriel* of The Northern Trust Company.

There is a lot in the press these days about how the recent rise in Treasury bond yields has the potential to abort a nascent economic recovery. To this I say, nonsense! Chart 1 shows that as the Treasury bond yield has risen in recent weeks, the yields on privately-issued debt have declined in absolute levels. Chart 2 shows that the stock market has been trending higher since March as the Treasury bond yield has risen.

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This combination of a rise in the Treasury bond yield, declines in yields on privately-issued bonds and rising stock prices is consistent with an asset allocation shift away from an asset with no credit risk to assets with credit risk. How can this lessen the chances of an economic recovery? If the current and increased supply of Treasury debt coming to market were “crowding out” private debt issuance, then the yields on privately-issued debt would be holding steady or rising in tandem with the rise in the Treasury bond yield. But again, yields on privately-issued debt are falling. In sum, investor risk appetite is returning, which is a good thing for the prospects of an economic recovery, not a bad thing.

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Source: Paul Kasriel, Northern Trust – Daily Global Commentary, June 9, 2009.

*Paul Kasriel is Senior Vice President and Director of Economic Research at The Northern Trust Company. The accuracy of the Economic Research Department’s forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul’s 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst.

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2 comments to Why are other yields falling as Treasury yields rise?

  • Ian Nunn

    It would be helpful for me to have more discussion around a couple of points.

    It is a casual observation that all rates shown in the first graph are trending to the level they were a year ago. If this reflects a readjustment of risk, then does it not simply reflect the level of risk of a year ago? I’m not a bond guy, but it seems to me yields price in at least three things, credit risk, inflationary expectations, and demand. Taking each in turn below:

    First is the statement “Shift away from an asset with no credit risk to assets with credit risk.” I realize it is a dictum of finance that Treasuries have no credit risk. But it is my sense that people are in the very early stages of questioning this. Trillion dollar deficits as far as the eye can see and new entitlement programs in the health arena, combined with the fact that unfunded liabilities of existing entitlement programs begin to come onto the balance sheet sometime around the middle of next decade (i.e. within the lifetime of a 10 year bond) might threaten the US’s AAA rating – if anyone is listening to ratings agencies.

    The US is the world’s largest sovereign and will entertain some form of default if and when it determines that this is the best way out of its problems: pure self interest. At least the Chinese may think so.

    Second, apart from credit risk, it seems to me the yield is simply pricing in the market’s assessment of future inflation. Monetary expansion to date – sorry QE to be euphemistically correct – is one likely source. Another, I think is the competition for scarce global capital. It seems clear from what others have written, that the Fed will have to purchase large quantities of treasuries – deficit + rollover of expiring Treasuries = a $4 trillion requirement this year alone for capital markets to absorb. And this new money from the Fed – however much – will not go into the excess reserves of the constipated banks, but directly into the economy.

    So how does this work? Ben needs to keep long-term rates down at least until housing turns around which, according to John Mauldin, is later 2010 or 2011. I wonder how he can do this without intervening heavily in the 10-year market to keep yields low while sopping up the government’s unmarketable credit requirements. If he does, the result is instant inflation which drives yields up. And Obama and the Democrats have left him no choice. However, this does not answer why yields on private debt are falling.

    I wonder if rates on private sector and government capital requirements are converging to a spread that is appropriate for what the market is expecting for inflation?

    Third point, about demand: “If the current and increased supply of Treasury debt coming to market were “crowding out” private debt issuance, then the yields on privately-issued debt would be holding steady or rising”. The data for April from the St. Louis Fed (Total Loans and Leases at Commercial Banks contracted by $42 billion in March) indicates that private sector credit and loans outstanding continue to contract except for real estate. In looking at “private debt issuance” the fall in aggregate demand along with reduced credit risk may be masking the effect of increased government demand, most of which is still ahead of us for the moment.

    Finally, to address the statement “How can this lessen the chances of an economic recovery?”, I don’t see an obvious causal connection between risk and economic recovery that the statement implies.

  • Well thought out Ian.
    I was also thinking that the data could be explained not by the Private Sector becoming less risky in Investors eyes but by the Government becoming more so (your 1st point).

    Some questions:
    In point 2 at the end, you question whether an adjusted spread between private and government bonds might be more appropriate to tackle inflation. I don’t see why this would be the case.

    In point 3, you only site data for March while comparing it to a trend in the graphs of yields since March to June. Has the private sector continually been trying to decrease it’s demand for debt since March?

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