In my opinion the 10yr Treasury is a great gauge of economic well-being in this country (currently at 2.22%). The unemployment rates identify those who have jobs versus those still searching. GDP tells us how well the economy performed a few months ago. But the 10yr Treasury is essentially a thermometer about that state of the economy today and likely in the near future. Post-election interest rates moved higher under the belief that growth, inflation and economic activity would accelerate. Fast forward 6+ months and we see a 10yr that continues to drop. Is a falling 10yr really a cause for concern?
I hate to sound like a broken record for quite some time now but the chance of a health care overhaul or tax code overhaul is looking very dismal. The Fed’s own prediction on future inflation has continued to decline and the price of oil has dropped from near $54 at the end of December to almost $42 per barrel a week ago. The Federal Reserve on the other hand has continued to raise interest rates. In the face of so much future economic uncertainty, the FOMC is pushing for higher rates. Why?
It all boils down to economic stimulus. Not only does the Fed provide monetary accommodation through the low interest rate policy but also through Quantitative Easing (QE), the program by which the Fed lowers rates through the purchase of Treasuries and mortgage-backed securities (MBS). The effects of both has helped the economy through the Great Recession, but the Fed wants to be cautious about creating too much stimulus causing uncontrolled inflation. I think it’s a well-established fact that uncontrolled inflation won’t be a problem we have to worry about.
Speaking of inflation, the Fed has not achieved it’s longer run target of 2% (Core PCE stands at 1.5% and likely will drop to 1.4%). The unemployment rate however is well below the 5% target (currently 4.3%). For the Fed this is where the road splits. Do you keep rates low and drive up inflation to 2% or do you raise rates and hope a tight labor markets raises wage inflation and the economy with it. The Fed has conveniently chosen option B, which is to raise rates and hope the low unemployment rate works its way into inflation. The reason the Fed chose this path is that, by raising rates, it affords them the opportunity to lower rates if the economy begins to slip. The other direction does not provide this flexibility. So will the Fed keep raising rates?
If they could, the Fed would. But the shape of the yield curve is telling the Fed to be careful. With the 10yr Treasury dropping while they raise short term rates is a signal that the market isn’t buying the wage inflation narrative. See graph below which shows the spread between the 2yr and 10yr Treasury, often referred to as the shape of the yield curve. A flatter curve means that 2yr and 10yr rates are converging which is what we have today. It’s the market telling you that inflationary pressures are very weak, despite what the Fed might say.
So getting back to the original point is that the Fed is taking a big gamble on wage inflation. If there isn't wage inflation, then there is no inflation at all because other sectors see almost no positive price pressure.