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The Bond Column

Treasury Yields Still Show Concerns About the Economic Recovery
Updated: 2015-05-25, 08:55:20 ET
Analyst: Jeff Rosen

Last year, we wrote an Economic Insight titled: "A Case for an Overvalued Treasury Market." Our main thesis was that Treasury yields were 55 - 75 basis points (bps) below what they should have been if the market was pricing a return to potential GDP growth in the five to ten-year time horizon. Our latest review of the data suggests ten-year Treasury yields are now 75 - 100 bps below a normal recovery rate.

Right after we produced that article in July 2014, Treasury yields moved in the opposite direction, declining by 85 bps to a low point in January 2015.

Since January, the 10-year yield has returned to roughly 2.30%. This last move, which many analysts have labeled as a "dumping" of Treasuries, has spooked equity markets. It seems that market participants may be seeing the current move in Treasuries as a sign that the bond market may be pricing in a sooner-than-expected rate hike.

But is that really the case?

In July 2014, the market was pricing in a fed funds rate of 2.10% 36 months out. Currently, the fed funds futures market is calling for a 1.79% fed funds rate in 36 months.



Since the middle of last year, the 36-month fed funds rate prediction has also followed a gently declining path.



That tells us that the market was much more optimistic about near-term economic growth in the middle of 2014 than it is today.

In fact, the fed funds futures suggest that the "New Normal" recovery will last longer than it did a year ago.

Using the same model that we detailed in that previous Economic Insight, Treasury yields should be closer to 3.0% if the market truly believes that GDP growth will average the long-term potential growth rate in the five to ten-year horizon.



Essentially, if the market expected the "New Normal" constraints to dissipate within the next five years, Treasury yields would match our predictions. In actuality, Treasury rates are further below our current prediction than they were in 2014.

If the equity market is truly concerned that the rise in Treasury yields is connected to a sooner-than-later increase in the fed funds rate, then it is mistaken.

--Jeffrey Rosen, Ph.D., Briefing.com