June 24, 2005, 8:38 a.m.
The 10-Year Conundrum?
What bond yields are telling us — and are not telling us.

By John Tamny

With the 10-year U.S. Treasury yield still causing confusion and debate among market watchers, former deputy Treasury secretary Roger Altman weighed with an op-ed in Tuesday’s Wall Street Journal. While he concluded that excess global liquidity explains today’s low long-term Treasury yields, he also reasoned that the bond market has simply overshot and that yields are suggesting slower economic growth in the future. All three assumptions rest on questionable economic and market reasoning.

Many have understandably made the point that the 10-year is overvalued, given the rise in the price of gold from $255 in 2001 to roughly $435 today. Since Treasuries pay in, and are priced in, dollars, it wouldn’t have been a reach to guess that their yields would have jumped substantially since 2001. Instead, the 10-year has seen its value increase 10 percent since September of 2001.

The above might qualify as a conundrum, unless you look to the price of the 10-year from 1996 until 2001 — a time in which the price of gold plummeted from roughly $385 to $255. Yields would have logically fallen pretty far at a time when the dollar’s value was rising. Instead, the price of the 10-year rose a mere 13 percent. (Note: As there is an inverse relationship between bond prices and yields, the relatively small price increase during the period denotes a relatively small drop in yields.)

These seeming price mismatches have existed ever since the U.S. left gold in 1971, and presumably reflect market uncertainty about what the Fed will do next — not to mention the power our central bank has over the direction of long rates.

The early 1980s are instructive in this regard. By 1980 the price of gold had reached $850 and the yield on the 10-year was 13 percent. As Ronald Reagan’s electoral hopes rose, so did interest in the dollar. By October of 1980 gold had fallen all the way to $450, and by January it was down to $390. Despite this substantial upward revaluation in the dollar’s value, 10-year yields actually rose, from 11 percent at the beginning of the year to 12.4 percent by year’s end. Four years later, gold fell as low as $305, but the 10-year yield was stuck at 11 percent.

Yields in the first half of the 1980s appear every bit as mystifying as the present yields. Looking back, confusion two decades ago seems well-founded, unless you remember that the fed funds rate was at times higher than the 10-year yield at the time. In addition, the markets were presumably still too spooked by memories of the 1970s inflation to bid yields down.

Presently, the rising gold price suggests that the yield on the 10-year should be higher. This makes sense until it’s remembered that traders must factor in the deflation the Fed engineered from 1996 to 2001, not to mention 200 basis points of rate hikes since 2004. The closely watched HUI “Gold Bugs Index” is actually down 3 percent in 2005, meaning the markets have apparently priced in falling commodity prices in the future. Today’s 10-year yield is perhaps an oddity given the present gold price, but it is less so when past Fed actions along with forward-looking commodity indices are factored in.

Altman’s second “alternate” assumption has to do with the economic growth outlook, and the possibility that falling yields indicate slower growth ahead. This assumes that rising/falling yields reflect rising/falling economic growth. Evidence dating back to the 19th century suggests that this assumption is false.

Adam Smith explained why in The Wealth of Nations. He wrote that “wherever a great deal can be made by the use of money, a great deal will commonly be given for the use of it; and that wherever can be little can be made by it, less will commonly be given for it.” Over two hundred years later the Wall Street Journal’s Robert L. Bartley noted in the The Seven Fat Years that the “savings pool available for borrowing expands and contracts with the fortunes of the economy.” In short, if money is stable in value, long rates shouldn’t move regardless of the rate of economic growth.

Nineteenth century England is but one example of the above reasoning. England was “banker to the world” during the Industrial Revolution, and as such its banks met the demands of capital-starved businesses around the globe. If what Altman is saying about interest rates and growth were true, rates would presumably have skyrocketed during the Industrial Revolution. In fact, yields on British 3 percent consols were nearly locked at 3 percent from 1843 to 1871.

Statistics from the Roaring ’20s are a little bit harder to come by, but one book (Banking and Monetary Statistics) published by the Fed in 1943 shows that U.S. government interest rates actually dropped from 4.8 percent in 1922 to 3.6 percent in 1929. Municipal rates hardly moved at all between 1922 (4.23%) and 1929 (4.27%).

Moving ahead to the 1960s, another period of above-average economic growth, 10-year yields stayed flat at roughly 4 percent following posthumous passage of the economy-boosting Kennedy tax cuts. A 10-year Treasury at 4 percent certainly didn’t foretell economic contraction then, and at 4 percent today it arguably isn’t telling us too much either. The correlation between rates and economic growth is greatly exaggerated.

Which leads us to what Altman deemed the “right answer” in the conundrum debate. He said “excess global liquidity” explains the present yield on the U.S. 10-year because money “has nowhere else to go but into dollar-denominated fixed-income assets like U.S. Treasury securities.”

His answer, on the face, raises red flags. Indeed, if dollar-denominated assets are attracting so much investment, why then has the dollar been so weak? Altman’s very own op-ed mentions the 1.3 percent yield on Japan’s 10-year, but it’s pretty well known that most buyers of Japanese debt are in fact Japanese.

Assuming Altman actually meant excess global dollar liquidity had nowhere to go but U.S. Treasuries, an obvious question follows: Why would investors want to hold securities that by definition are steadily losing value? Logic says investors would not want to own a falling asset. In addition, the chart of the 10-year provided by Altman tells us why his assumption is likely incorrect: It’s incorrect because we’ve experienced periods of excess global dollar liquidity before, most notably from 1976 to 1980. During that time the price of gold rose from a low of $105 all the way to $850. This was serious dollar liquidity that resulted in a run on real estate and a major sell-off in the Treasury market.

Time will tell as to who is right regarding the U.S. 10-year Treasury yield. Altman’s reasoning quite simply does not stand up to history. More broadly, if the value of the dollar versus gold is looked at in isolation, the 10-year yield might seem alarming. But Treasuries have never moved in day-to-day lockstep with the dollar. Instead, past, present, and projected future action by the Fed all factor into the price of Treasuries.

— John Tamny is a writer in Washington, D.C. He can be contacted at jtamny@yahoo.com.

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