Both Macroblog and Capital
Spectator raise the prospect today that rising long-term yields might mean that the Fed
waited too long before trying to stamp out the cinders of an incipient inflation fire. I would
suggest instead that the increase in long-term yields over the last few months is the natural
development that we expect to see in a situation of Fed tightening and has little to do with
The long-term interest rate is driven by two factors– expectations of where future short
rates are headed, and investors’ preferences for short-term versus long-term holdings.
Mathematically, the 10-year rate can be written as the sum of the discounted present value of
the market’s expectation of future 3-month rates over the next 10 years plus a term premium.
That decomposition is actually just the definition of what we mean by the term premium, but it’s
a definition that can be a useful way of thinking about what accounts for changes in long-term
When the Fed is raising short-term rates rapidly as in the present environment, there are
several reasons why longer term yields could change. If the Fed is expected to continue
tightening, near-term short rates are headed up, and through the expectations component (the
first term in that decomposition of the 10-year rate), this would be a factor driving the long
rate up. Short rates at more distant horizons might be expected to change in either direction–
down, if the market believes that the Fed will be successful in slowing the economy and bringing
down inflation, or up, if the market discovers that there really was a stronger economic boom
and a bigger inflation threat than it had previously recognized. As far as the second term in
the decomposition is concerned, the effect of rapidly rising short rates is usually to drive the
term premium down.
|Episode||Fed funds change||10-year change|
|1958:05 – 1959:07||2.84||1.48|
|1967:05 – 1968:07||2.08||0.65|
|1972:01 – 1973:03||3.59||0.76|
|1983:06 – 1984:08||2.66||1.87|
|1988:01 – 1989:03||3.02||0.69|
|1993:11 – 1995:01||2.51||2.06|
|2004:06 – 2005:08||2.47||-0.41|
As a theoretical matter, then, it would seem that the long-term yield could either rise or
fall as a result of rapid Fed tightening. The historical experience, however, is that it almost
always seems to go up. The table on the right looks at the seven episodes over the last half
century when the Fed drove the fed funds rate up by more than 200 basis points within the space
of a year (not including the hectic 1979-82 period when there were all kinds of wild swings in
interest rates). The table summarizes the change in the fed funds rate and the 10-year Treasury
yield over the 14-month period following the first funds rate hikes. Up until the current
episode, in every single one of these episodes, the long rate rose along with, but not as much
as, the short rate.
Given these numbers, it might seem surprising that some analysts are thinking of rising
long-term yields as a source of concern in the current episode, since, in contrast to every
previous episode, long yields still stand significantly below their values of a year ago. I commented earlier on
this anomalous behavior of long yields in the current episode, coming to the conclusion that the
fall in yields over the last year was largely due to a decline in the term premium.
|Instrument|| Change over |
last two months
|10-year TIPS|| 0.32|
The reason that some analysts are nevertheless currently talking about rising long-term
yields is that, over the last two months, the trend in long yields has reversed, and long-term
rates have come back up significantly. However, even if we only focus on the last two months,
the rise in long rates is less than the rise in short rates. It’s also interesting to note that
inflation-indexed Treasuries have gone up together with the 10-year nominal yield, suggesting
pretty strongly that it’s not inflation fears that have contributed to the increases in the long
rate, at least up to this point. Instead it looks much more like the market has come to expect
hikes, driving the 10-year rate up through expectations of a higher fed funds rate over the
next few years.
Granted, the concerns that others have raised have to do not so much with the hikes in long
rates that we’ve seen so far, but rather with a climb in long-term yields that some traders are
expecting may be yet to come. But Dave Altig is
quick to point out that nobody has a very compelling track record for making such
Spectator’s concerns hinge on the possibility of further big oil price increases.
I suggested last
week that concerns about stability in Saudi Arabia have been responsible for the latest
moves up in oil prices, a factor of course increasing significantly just today. Oil prices have gone up so far based on the still
relatively small probability of a major disruption. If there is major civil upheaval in Saudi
Arabia, then yes, we’d have some more inflation in the U.S. But it strikes me that would be the
least of our problems.