In the last few days the yield on the 10-year Treasury note has tumbled from 1.6% on Monday, March 8, to 1.54% on Tuesday to 1.52% today.
That’s brought a breather selling that had, by Monday, pushed the NASDAQ Composite index into a correction of around 11% from its February 12 high
Yesterday and today, the market is as relatively calm place. Cyclicals, vaccine recovery stocks, and “value” stocks are outpacing the technology sector and the BIG tech stocks like Apple (AAPL) and Amazon (AMZN) that had paced the move up to the February 12 high aren’t showing up on the leader board. But still–the Dow Jones Industrial Average may be outpacing the NASDAQ Composite today (up 1.57% to 0.31%) but both indexes are in the black.
But don’t relax quite yet. I expect volatility will return. Because the financial markets have to cope with the historically wide gap between projected economic growth in 2021 and the current yield on Treasuries. And, historically again, closing that gap has been messy.
What gap am I talking about? It’ the one between projected economic growth and they’d on 10-year Treasuries. The gap between the 10-year yield at 1.6% or so and the estimates of U.S. economic growth hasn’t been this side since 1966. And as Bloomberg put “that suggests the climb in rates may still have room to run.
Economists and Wall Street strategists have been busy pushing up their projections for nominal growth (that’s including inflation) for U.S. GDP to a 32-year high of 7.6%, according to Bloomberg surveys.
Meanwhile even though the yield on the 10-year Treasury has doubled since November to the vicinity of 1.6%, it has been left in the dust by the increase in projected growth. For example, while Goldman Sachs has raised its forecast for yields on the 10-year Treasury to 1.90% by the end of 2021 from 1.50%, the forecast for GDP growth has climbed steadily to 7.6% with 5.5 percentage points of that coming from real economic growth and 2.1 percentage points coming from inflation (as measured to the PCE, the Fed’s preferred inflation gauge.)
There isn’t a fixed stable relationship between bond rates and economic growth–although it’s clear why the two rates are connected. Higher economic growth has, in the past, tended to go along with higher inflation and higher bond yields. It’s just that, this time, we’re starting from abnormally low rates to address an emergency (that were piled on top of abnormally low rates that have become normal in the last decade or two) and an economy that was quickly sent into a deep, deep recession by a global pandemic.
A divergence like that today has been rare, Bloomberg notes, with nominal GDP growth running at less than 2 percentage points above the 10-year Treasury yield in the decade through 2019.
To get back to the neighborhood of that relationship nominal economic growth rates would need to drop to 5% while bond yields would need to climb to 3% from 1.60% today. (And at a nominal GDP growth rate of 5%, the real, inflation excluded growth rate in this scenario would be something like 2% to 3%)
Getting to that relationship would not be a smooth transition. We’d have multiple bond market tantrums as yields on the 10-year Treasury moved above 2% and then kept on climbing. The financial markets–and regular walking around and consuming and saving Americans–wouldn’t be happy with real growth that fell from 5% to 3% or 2%. (Even though that is what economists are forecasting for the economy after this year’s big bounce from the coronavirus recession.)
If you’re old enough–or enough of an old car buff–to hark back to the days of manual transmissions, you’ll remember that frequent grinding of gears (and a stall or two) as a driver shifted gears.
I think that’s a good analogy for what we can expect in the markets going forward. Not necessarily a big concentrated drop but certainly repeated bouts of volatility.
