Photo: Wikimedia Commons
The current title on our CHART OF THE DAY today is simply 1.53760 per cent, which represents the current yield on a U.S. 10-year Treasury.For folks in the financial industry, that number is “mesmerizing,” but we also recognise that a huge swath of the population has no idea what this means or why it matters.
The public has only a basic grasp on what any given stock market index level means, and the media does a MUCH worse job dealing with the bond market.
So let’s explain.
The U.S. Treasury rate just represents the rate at which people are willing to lend money to the U.S. government. So when the 10-year U.S. Treasury is at 1.53670 per cent, it means people are willing to lend to the government, and receive only 1.5370 per cent interest each year for the next 10 years.
If you lent the government $100, each year you’d get a payment of about $1.53 (the principal is ony repaid at the end of the 10 years).
The important question is: Why are people willing to part with their money for so long and receive such a pittance in payback? The government’s debt-to-GDP is about 100 per cent, and many mainstream pundits, politicians, and economists warn about an imminent U.S. debt crisis ala Greece.
Well, the fact of the matter is that the size of the U.S. debt or deficit just doesn’t matter that much. Actually, it’s never mattered at all.
Here’s a look at the size of the national debt (red line) vs. the yield on the 10-year (blue line) going back to the late 1960s.
So if the size of the national debt doesn’t matter, then what DOES affect the rate at which people will lend the government money.
A few things matter.
One of them is inflation. When people think that inflation is high (meaning that the value of their dollars will erode rapidly) they will want a high return from the government.
It’s not a perfect alignment, but you can see that the yield on the 10-year bond (blue line) matches up over time with the year-over-year change in the CPI (the most mainstream measure of inflation).
Another factor that matters is growth.
Growth is critical because if you think that the economy is going to grow in a robust fashion, then you won’t want to lock up your cash with the government. You’ll want to invest in real things or at least stocks that might boom along with the economy.
It’s not perfect, but if you look at the 10-year rate (blue line) vs. the year-over-year change in the GDP, you can see that rate movements line up pretty nicely with changes in growth.
There’s another factor that’s mattered a lot lately: FEAR!
If you think that everything is going to collapse (for example Europe’s economy completely imploding in a crisis that makes Lehman’s aftermath look like child’s play) all you’ll want to do is give your money to the one entity that has unlimited (thanks to the printing press) power to pay the money back.
This chart again isn’t perfect, but if you compare 10-year rates (blue line) with the VIX (a measure of market fear) you can see that they move together. (In this chart we’ve inversed the VIX, so that it goes down when it’s spiking).
So then let’s back up …
Yields have been collapsing furiously.
What does it mean?
Well it means that people are worried that growth is slowing (see: all the bad data out this morning), inflation is abating fast (oil is below $88/barrel these days) and people are FEARFUL (see: all of Europe). Thus we get the massive inflow of cash into Treasuries. It’s a cliché, but in times like this, people don’t care about making money. They just want to know that if they put their money somewhere, it will be there the next year or the next decade.
There are other interesting factors at play as well.
In the past, most of Europe was seen as a big, safe economy. But the number of obvious safe havens in Europe has shrunk to basically just Germany, so that makes the demand for U.S. debt even more acute. There also used to be an abundance of government-backed housing debt, but that market has shrunk as well.
Cardiff Garcia at FT Alphaville has dubbed this chart the most important chart in the world, since it shows that since 2007 there’s been an ongoing decline in AAA-rated securities around the world. The only area that’s grown is sovereign debt, and even this is out of date, since so much of Europe is no longer AAA-rated.
Photo: FT Alphavilled
So you have no growth, no inflation, huge fear, and a shortage of safe assets. Understand this, and you start to grasp why there’s incredible demand for U.S. Treasuries, and why interest rates are at record lows.
Now we want to address one big myth about low interest rates—that they’re the result of the Fed buying a lot of Treasuries, and keeping them artificially low.
This just isn’t backed up by recent history.
This chart from Jeff Gundlach is a little old, but it shows clearly that each time the Fed initiated a round of quantitative easing, interest rates actually went up, not down.
You can click the chart to enlarge.
So what we’re seeing in this combination of fear and despair and low interest rates really is history.
The path of U.S. interest rates is following the same path as Japan, which is in one of the most famous/longest slumps of all time.
And in U.S. history, we’re talking about financial history that spans the entire Republic.
We’ll end with this chart from Bianco Research, posted previously by Barry Ritholtz, which looks at rates going back to 1790.
Photo: Bianco Research