How would you like a deal where you get to take on a meaningful risk of losing money for a whopping 2 percent annual return?
That’s the conundrum that has faced U.S. bond investors for most of the last five years; 10-year Treasury bonds haven’t yielded so much as 4 percent since October 2008, and for the last two years they have frequently lurked below 2 percent. That means someone who buys Treasuries is exposed to various types of risk — that inflation will turn sharply higher down the road, that the Fed will raise short-term interest rates sooner and faster than expected or that the United States could face a debt crisis — with only the most modest of compensation for the privilege.
And the shockingly amazing thing is how consistently the people who took that bet anyway have done better than those who took the other side of the bet and short Treasuries. The story of the last five years has been that whenever rates seem to be heading upward and the great bond market selloff has arisen, soon enough we get the return of gloomy economic data, a new wave of easing from the Federal Reserve and yet another leg down on interest rates.
Which brings us to the current rise in rates that has Wall Street aflutter. The bond market bears had a pretty spectacular May, as the 10-year rate rose from 1.63 percent on May 1 to 2.15 percent Friday. (The price of bonds moves in the opposite direction of yields). Is it a moment of reckoning that will stamp out the recovery or presage dangerous inflation or massive losses by bond investors? Or is it something more positive? Let's look at the evidence.
As economist Paul Krugman discusses here, the apparent mystery of why rates are on the rise seems to have a good answer. Consider the possible explanations (I would add a fourth to Krugman's three), and why many of them don’t quite hold up:
• If investors had grown fearful of a Greek- or Spanish-style debt crisis, then the rise in bond yields would likely have been accompanied by a falling stock market. Instead, the Standard & Poor’s 500 index is up 4.7 percent since May 1.
• If investors were betting inflation would rise faster than they had thought, it would show up in the relative prices of bonds that are and are not linked to inflation. But that measure actually shows that inflation expectations have been falling over the last month; over the coming decade, bond prices imply that investors foresee 2.2 percent annual inflation, down from 2.3 percent on May 1. This chart shows these so-called Treasury break-even rates, which amounts to forecast inflation:
• And if investors were betting not on the economy getting better, but rather that the Fed would take a more hawkish turn in the future, regardless of how the economy performs (for example, if investors became convinced that President Obama would pick bubble-phobic Fed governor Jeremy Stein over more dovish vice chair Janet Yellen to succeed Ben Bernanke), you would expect the rise in interest rates to be accompanied by a stronger dollar. The dollar index (measuring it against six major currencies) is indeed up about 2.5 percent over the last month, and the biggest moves in markets have been in response to chatter by Fed officials, so this explanation can't be ruled out. At the same time, the rise in the dollar seems to be driven more by changes in the stance of the Japanese and European central banks, not by what happens stateside, so it's a less compelling story than it might seem.
• Which leaves the final explanation that seems to best fit the evidence. Investors are becoming more confident that growth will be solid in the years ahead and thus persuade the Fed to hike interest rates a bit sooner than seemed likely. In that case, for longer-term Treasury bonds to be fairly priced, they would need higher rates, as well. If this explanation is true, then the slight uptick in interest rates from such low levels shouldn't be enough to undermine the nascent housing recovery.
There is one important caveat, though. We've seen financial markets in other countries become dramatically more volatile in the last few weeks, particularly in Japan and to a more modest degree in the United States, as traders react and often overreact to kernels of news about what central bankers will do in the future. That may be an undesirable side effect of our times, when so much of market activity is driven by extraordinary interventionism by the world’s central bankers. It could also mean that the normal market signals aren't as reliable as economists like to think they are.
But to the degree that the dashboard we study -- the various screens that pop up on a Bloomberg terminal -- is reliable, it is pointing toward interest rates that are rising for good reasons, not bad.