Markets and Economy
The Implications of Rising Yields
Rising Treasury yields caused a drop in equity markets, suggesting investors were concerned over the interest rate outlook. But interest rates haven’t always been this low, and rising yields are a sign of overall economic strength.
At the end of January, equity markets shuddered as Treasury yields continued to climb. The yield offered on 10-year Treasurys, often seen as a proxy for long-term interest rates, has risen nearly half a percentage point since the beginning of the year. The 10-year yield is currently sitting near 3 percent, a level that has not been sustained since the Federal Reserve launched its second round of quantitative easing in 2010.
The prospect of higher real interest rates—and the stock market’s gyrations—have some commentators worried. Are rising yields a symptom of uncertainty about the nation’s fiscal outlook?
It seems more likely that investors are simply gaining confidence in the economy’s ability to support normal interest rates. With the Fed trimming its balance sheet, the distortions from quantitative easing are fading and yields are rising toward a natural equilibrium. Rather than a sign of brewing turmoil, higher yields may be a sign that the economy is back on solid footing.
Confidence in Normalization
When the Fed first announced its intention to gradually normalize interest rates, futures markets were skeptical. Even after the initial rate hike in late 2015, futures markets were reluctant to price in the full program of interest rate normalization. For years, private investors predicted a much shallower trajectory for rates than the forecasts issued by the Federal Open Market Committee.
Over the past year, however, the tightening labor market and solidifying price pressures have given the Fed’s plan greater credibility. Futures markets have aligned their expectations with the Fed’s forecasts; both now call for short-term rates to gradually climb toward 3 percent over the coming years.
There’s still considerable debate over whether 2018 will bring two, three or even four interest rate hikes, but investors broadly concur that interest rates will continue to rise as the peak of the business cycle approaches and inflation moves toward the Fed’s 2 percent target.
Some commentators are growing concerned that the economy will overheat and interest rates will rise abruptly, but these fears seem premature. If an inflationary spiral were to force the Fed to hike interest rates ahead of schedule, bond markets may react. But the Fed’s rhetoric has emphasized its commitment to a gradual pace of normalization. Policymakers believe the labor market still contains hidden slack, and relatively tame inflation over the past two business cycles implies that the economy’s potential for growth is more flexible than traditional models assume.
The Fiscal Horizon
The current fiscal outlook points toward rising yields, but the forces driving up borrowing costs will develop gradually, with interest rates evolving in response to structural forces.
The widening federal deficit is poised to support higher interest rates over the coming decades. As the US’s population ages, the federal government is projected to borrow ever larger sums to finance its healthcare and Social Security obligations, and competition for capital will naturally push up borrowing costs.
However, the long-term outlook is not set in stone. The recent tax reform package may boost growth, which would ease the burden of future borrowing. And there’s still time for entitlement reform to temper fiscal imbalances before they stress markets.
The current movement in interest rates is a return to normal, not a sign of uncertainty. And the nation’s long-term fiscal challenges, while real, are likely to unfold slowly. Rising yields and normalizing interest rates are widely expected. They’re unlikely to create significant turmoil for the market.
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