Lately we’ve been discussing whether the flattening yield curve is indicative a coming recession or if yield on the 10-Year crossing above 3% would choke off growth and tip a sell-off in stocks. A recent article in Bloomberg suggests that neither should be a cause for concern, pointing to current patterns in options trading as evidence that market participants are not greatly worried about a sudden surge in interest rates.
When the yield on 10-year U.S. Treasury notes reached 3 percent on April 24 for the first time in more than four years, investors began to wonder whether it represented a tipping point that would cause borrowing cost to surge even higher at an accelerating pace. Options prices, which contain valuable information about the market’s assessment of near-term upside potential and downside risk for a wide range of assets, show few indications that rates will suddenly shoot higher, for two primary reasons.
First, for the rate at which bonds are selling off to accelerate sharply, there would have to be a large and sudden exodus from Treasuries into another, more attractive substitute asset. But across the developed world sovereign debt yields are much lower, at less than -1 percent on German and British 10-year bonds and below -0.5 percent for Japanese government bonds, versus a real yield on the benchmark Treasury of 0.8 percent.
While momentum traders will certainly short Treasuries, the impact is not likely to be substantial. Overseas governments, federal agencies, the Federal Reserve, mutual funds, pensions, insurance companies and endowments collectively control about 93 percent of the U.S.’s $21 trillion of national debt. These are not wholesale sellers and, realistically, they have nowhere else to park their money.
Consistent with this, option prices show a preference for Treasuries. For example, the implied volatility on 10 delta three-month puts is nearly one volatility point higher than accompanying calls for 10-year German and Japanese government bonds, but only 0.2 volatility point higher for Treasuries. The option market is therefore saying there is more risk to the downside for German and Japanese bonds compared with their U.S. counterparts. With no attractive substitutes available, wholesales shifts away from U.S. debt are unlikely.
Indeed, rising yields may attract overseas money, constraining the pace of any selloff. On April 26, Bloomberg reported that several Japanese insurance companies – risk averse and cautious by nature — are opting to buy more Treasuries without a currency hedge because the yield differential between U.S. and Japanese government bonds is now so wide that the extra cost for protection isn’t merited.
The second reason yields could jump quickly would be if there was a sudden inflationary shock. Inflation erodes the value of a bond’s fixed coupon and principal payments, leading investors to demand higher yields.
However, aside from a commodity disruption, there are few signs of a significant increase in inflationary pressures. That’s largely because the Federal Reserve began tightening monetary policy well before signs of faster inflation appeared. In addition, technology has brought down barriers and heightened competition in every sector, reducing pricing power and likely keeping a lid on prices.
Although options trading doesn’t point to U.S. yields rising at an accelerating pace, yields are likely to continue to climb as the Fed continues to normalize monetary policy. Years of ultra-loose policy has left real rates – or interest rates less inflation – artificially low.
Yields on 10-year Treasury Inflation-Protected Securities are around 0.8 percent, suggesting that the bond market sees an average rate of real gross domestic product growth in the U.S. over the next decade of about 0.8 percent. Most economists would argue that normalized real GDP should be around 1.5 percent to 2.0 percent. So, real rates still have the potential to rise by at least another 0.7 percentage point, implying a fair value for the benchmark 10-year Treasury of about 3.7 percent.
So while the trajectory of 10-year Treasury yields remains up as real rates rise, 3 percent isn’t a tipping point based on options market prices, and any selloff should be controlled in the absence of outflows to other developed-market sovereign debt assets and/or sharply higher inflation.
It’s not about the ultimate level of yields, but the path they take. A violent surge in real yields would likely not be welcomed by the market, while a controlled and gradual rise in the real cost of capital can certainly be absorbed.
