A Milestone, of Sorts

This is one of those milestones (in some ways like the Dow breaching 10,000) that obviously means nothing from a strictly financial point of view, but is an important psychological threshold. If nothing else, this news draws our attention to the real story, which is the slow but steady upward march of interest rates that we’ve seen in recent months.

Yield on 10-year note climbs above 5%

NEW YORK (MarketWatch) — Treasury prices were under pressure Thursday, pushing the 10-year yield above 5% for the first time in nearly four years, as unexpectedly strong retail sales and consumer-sentiment data advanced a case for the Federal Reserve to keep lifting rates.

This rise in rates reflects a belief that the economy will continue to remain strong through the rest of the year. That belief pushes long-term interest rates higher due to three factors, which are all interrelated. A rough attempt at disentangling their relative importance is presented in the following picture.

First, a stronger economy will persuade the Fed to keep raising short-term interest rates. Higher short-term rates (the red line on the graph above) tends to push up long-term rates, since people tend to demand at least as high a rate of interest on longer deposits as they’re getting on short-term deposits.

Second, a stronger economy will tend to cause inflation to rise. If prices are expected to rise more, then investors will demand a higher rate of interest to compensate them.

Finally, a stronger economy will tend to cause the real (i.e. after inflation) rate of return to rise, since the demand for borrowed funds will typically be greater during a period of strong economic growth.

The graph above illustrates that much of the recent rise in long-term rates is due to this final effect. Since the end of January, the yields on inflation-adjusted bonds (TIPS) have risen almost as much as yields on nominal bonds, suggesting that the rise in nominal bond yields is not primarily due to fears of higher future inflation.

As for the effects of these higher long-term interest rates on the economy… I would suggest paying close attention to the real estate market.