What will the yield be on the 10-year US Treasury bond in six to twelve months? The question has implications about not only the bond market, but the stock market and the economy as a whole. That was the question posed to a panel at the 7th annual Northern California Wealth Management Forum. I was one of four panelists, and my answer was very different from the others.
On June 6, 2023, the 10-year Treasury bond was yielding 3.7%. One panelist thought it would hold about the same; two panelists thought the bond would be at 3.2% or lower. I said 5% or more. That answer raised eyebrows. But I had what I thought were excellent reasons for my answer.
But first, we must have a quick crash course on the inverted yield curve. This has been a hot topic for many financial experts have been discussing what they inverted yield curve is “telling us”. The claim is there has never been an inverted yield curve that was not followed by a recession. Of course, I believe that things that have never happened before happen all the time.
I have never known a bond, a bond fund, or even a yield curve to “tell” us anything. What we can learn from the yield curve, whether inverted or not, is what investors, both from the United States and other countries, feel about the future of the US and world economies, the stock market, and the bond market. After all, investment decisions are made by millions of people who come from different backgrounds, different educations, different psychological makeups, different social situations, different countries, , and different cultures.
The treasury market is an auction market where sellers are matched with buyers. The market is international, and trades occur 24 hours a day, seven days a week. The US treasury is the most traded security in the world.
What does it mean when the yield curve inverts? It might mean that buyers expect inflation to come down, or the international economy could be disrupted by something – like the war in Ukraine – or another major geopolitical event.
At the panel, it was obvious the other speakers had bought into the idea that the United States was headed into a recession, and the Fed was going to bring inflation down.
I do not. There are four reasons I believe the rate will be 5%, and those reasons will have implications for the bond- and the stock markets.
First, inflation has been sticky. The core PCE (Personal Consumption Expenditures) has barely moved in the last 18 months. Those are the expenditures for essentials like eggs and milk, for eating out at restaurants, and for travel and entertainment. Historically, these expenditures have been closely related to wages, and wages have been rising at a five percent clip (5%). Yes, the rate of growth has slowed from a little over 5% to 4 ½, but that change took over eighteen months to occur. There are between five and six million more open jobs than there are workers to fill them. And that situation is getting worse, not better. Since 2009, there have been about 200,000 net new jobs being added every month, but fewer than 100,000 workers are joining the work force. This is something we have not seen before. Previously, when the Federal Reserve was raising rates, there were each month fewer net jobs (and sometimes more layoffs than new jobs being created). Things that have never happened before happen all the time. Until this trend reverses, inflation is going to be difficult to bring down.
As long as employment remains high, the likelihood of a recession is not very high. If anything, that has been verified by the outlook of much of the financial community. They predicted a recession to begin in early 2022 as the Fed began to raise rates. When that did not happen, they predicted it again in the second half of 2022. When that did not materialize, they forecast the recession in the first half of 2023. Now that we are ending the first half of 2023 without a recession, they are now convinced it will be here by the end of 2023. They rely on the yield curve, and the yield curve has been inverted for eighteen months.
The second reason I gave at the panel is that the Federal Reserve is deleveraging their balance sheet. The Fed is selling $1 trillion of bonds, which will “de-print” money. In addition, the Treasury must finance or refinance $1.5 trillion of bonds and notes. That is a significant amount of selling that needs to be absorbed and could by itself pressure interest rates.
The third reason is that wars are usually fought slowly but won fast. I feel the war in Ukraine will probably be over by this time next year. When that happens, the geopolitical upset of that war and its consequences will evaporate, and some central banks will be reducing their bond holdings. If rates are moving up, the prices of those bonds will be moving down, and the central banks will dump to avoid capital losses.
The fourth reason was evident from the sessions on equity stocks. There were two sessions on the stock market going forward in the next twelve months. The panelists said indirectly or even directly they were 15% or 20% or 40% or 50% in “cash”, which usually means bonds. When they realize the market is moving up, and the recession will not materialize, they will be dumping their bonds and adding to the other sellers.
My reasoning did not seem to convince anyone, but I often run contrary to the general mood of the bond and stock market. Only time will tell who is correct in their assessment.
It is always dangerous to say “this time is different”. In the past, when the Federal Reserve has raised interest rates, the economy fell into a recession. When last year the Fed began raising rates, tons of gurus predicted the recession would be underway before the end of the first quarter of 2022. When that did not happen, they said it would be the end of 2022. By the end of last year, the prediction was early 2023. Now they predict a recession by the end of this year.
Normally, when the Fed raises rates unemployment rises, people begin to quit buying clothes, stop going out to eat in restaurants, and generally curtail their expenditures. This has not happened. This time really is different. That could change, but until it does, I do not see a recession in the immediate future, and rates could very well be above five percent in twelve months.
