MorningWord 8/19/16: Why Be Normal?

by Dan August 19, 2016 10:09 am • FREE ACCESS

Despite mounting pressures, both internally and externally, for a divided FOMC (as evidenced by the July minutes) to raise short term interest rates for only the second time since June 2006, the yield in the 10 year Treasury bond remains 25 basis points from its 52 week and all time lows, and 75 basis points below its 52 week highs.  The yield appears to be basing above the prior lows following two consecutive employment reports (June & July), and with a third (Aug) due on Sept 2nd, we might finally see a move back towards the 200 day moving average at 1.85%, suggesting the markets ease with a 25 basis point fed funds increase by year end:

US 10yr Treasury Yield 1 year chart from Bloomberg
US 10yr Treasury Yield 1 year chart from Bloomberg

On Wednesday in this space (MorningWord 8/17/16: Rates of Change), I gave my view of the likelihood of a hike prior to the presidential election:


I get why there is a growing chorus to normalize rates, especially if employment gains continue at above average, but it’s also important to note that the other half of the Fed’s dual mandate, inflation remains well below their target.

Earlier in the week, San Francisco Federal Reserve Bank President John Williams (non voting member) weighed in, offering a warning on inaction if the Fed waits to raise until they achieve prior targets set for their dual mandate:

“If we wait until we see the whites of inflation’s eyes, we don’t just risk having to slam on the monetary policy brakes, we risk having to throw the economy into reverse to undo the damage of overshooting the mark,” he said. “And that creates its own risks of a hard landing or even a recession.”

Bond traders don’t appear to be worried about a 25 basis point raise. If they did, the 2o year chart of the 10 year Treasury yield would not look like this, meaning so far away from the long term trend, we would likely see this yield back towards 2%:

US 10yr Treasury Yield since 1996 from Bloomberg
US 10yr Treasury Yield since 1996 from Bloomberg

This is obviously unscientific musings from an equity monkey like myself. But the world is in a bizarro yield environment at the moment. These are unprecedented pricing distortions. The inability for rates to rise here in a meaningful fashion given the relative strength of our economy is troubling.  I’ll also note that the two circles above, that represent the peak in the 10 year Treasury yield in 2000 at 6.85% and at 5.33% in 2007 were followed by declines in the yield of 50% and U.S. equities dropping in a commensurate fashion. With Fed Funds at 25 basis points, and the 10 year Treasury yield at 1.56%. It brings me back to what I think will prove to be a prescient piece by the WSJ’s John Hilsenrath nearly a year ago on August 17th, 2015:


This is not a warning. I’m not sure ow all this plays out. But I want to highlight that despite all time highs in U.S. stocks, and the apparent easing of financial conditions across the globe, the framework for higher highs in stocks is precarious at best. It’s still a wall of distortions being climbed. While most acknowledge the potential for risk asset prices to go higher in the current rate environment, the worry is that they do so for the wrong reasons.  But at this stage of recovery, you gotta scratch your head at this sort of out-performance. Especially when you consider how much of the S&P 500’s performance in the last few years has been fueled by growth stocks.