Interest rates rose meaningfully this week. After nearly testing the historic low of mid-2016 in September, the 10-year Treasury note yield has increased almost half of a percent. Optimism for a trade deal between the U.S. and China has resulted in some optimism for economic growth and support for higher interest rates. Other factors that have impacted rates include a better-than-expected corporate earnings season and a pause in Federal Reserve policy. The move higher in the 10-year rate, along with Fed rate cuts and quantitative easing applying pressure to short-term rates, has un-inverted the yield curve. The normalization of the yield curve helps reduce anxiety about economic growth and recession outlook over the near term.
The interest yield on 10-year US Treasury notes, generally viewed as the bellwether interest rate of the economy, rose by approximately 0.20% this week to close at 1.93%. This move represented a big turnaround from just a month earlier when the 10-year rate slumped to a three-year low of 1.46% on September 3rd. Just on Thursday, the 10-year rate was up 0.15% at the intraday peak – the largest one day move since the day after President Trump was elected.
So, why are interest rates moving higher?
1.) The easing of trade tensions between the U.S. and China. It’s been the most closely watched issue in capital markets as the world’s largest two economies have traded tariffs, boycotts, and slights. The first thawing of the cold front came in mid-September when the U.S. agreed to delay increasing tariffs, and China renewed soybean purchases after being mostly absent in the market. Talks in early October concluded in the announcement of a “Phase 1 deal”, which largely echoed and reinforced the September agreement. Even though officials are still working on the actual text and an opportunity to sign this Phase 1 deal, there was continued optimism in headlines this week. On Thursday, there were reports that tariffs could be rolled back as a part of the agreement, which led to the move higher in interest rates. The Trump administration would later temper those reports.
As optimism rises around trade progress, economic growth expectations will rise and take interest rates with them. The U.S. and China are also the most significant contributors to economic growth, in addition to being the two largest economies.
2.) Third-quarter corporate earnings beating expectations. Per I/B/E/S data, 446 of S&P 500 companies have reported earnings 3rd quarter earnings and 74.2% have beat analyst estimates, compared to a long-term average beat-rate of 64.8%. The estimated earnings growth rate for the S&P 500 for Q3 2019 is nearly holding pat at -0.5%, but if the energy sector is excluded (-37.8%), the growth rate improves to 2.1%.
Analysts had adjusted down third-quarter earnings expectation to a loss of 3% at the start of the reporting season. Due to the beat-rates, earnings appear closer to flat for the quarter, and investors may be willing to reward these companies and take on more of a risk posture. As demand subsides from one of the most relatively safest asset classes in the world in US Treasury notes, their yields will rise.
3.) The Fed hinting at the end of rate cuts. After the Federal Open Market Committee’s third 0.25% cut of the year at the end of October, Chairman Jerome Powell remarked that as long as the economy expands moderately and the labor market stays strong, “the current stance of [interest-rate] policy is likely to remain appropriate.” This remark implied that they would need to see marked deterioration to GDP and employment figures to enact another rate cut.
This point may be taken with a grain of salt because the federal funds rate should only impact short-term rates, not longer-term maturities like the 10-year; however, the 10-year Treasury yield and implied Fed policy have traded in lockstep all year (see the chart below). Therefore, when the Fed signaled that it might be done cutting the federal funds rate, even the 10-year Treasury yield may have naturally floated up.
Yield Curve Impact
The Federal Reserve has also revived its bond-buying program, in addition to cutting the federal funds rate. We’ve covered in recent Weekly Insights that the Federal Reserve has authorized the purchase of $60 billion per month of short-term Treasury bills “as necessary to maintain an ample supply of reserve balances over time.” This bond-buying program, which we’re not supposed to call quantitative easing, along with federal funds rate cuts, has pushed down the shorter-term Treasury yields. When you combine this downward pressure to the front end of the yield curve with the move higher in longer-term interest rates, the yield curve has un-inverted.
The 3-month and 10-year Treasury yields had been inverted (3-month paying more than the 10-year) for the better part of six months. At its trough on August 28th, the 3-month Treasury was yielding 0.52% than the 10-year Treasury yield.
An inverted yield curve has been a reasonably reliable economic recession indicator as it has inverted preceding the last seven recessions going back to 1965. This track record led to some justifiable nervousness among investors (and advisors).
The good news is that the 3-month and 10-year yields un-inverted on October 11th – the date of the Phase 1 US-China deal announcement – and steepened to a positive spread of 0.39% as of Friday.
We also keep an eye on the 2-year and 10-year spread because the 2-year Treasury is less apt to be impacted by Fed policy. It also has a tighter warning period.
Unlike the 3-month and 10-year inversion, the 2-year and 10-year only stayed inverted for three days, far less than a full quarter. Its trough was -0.04%, and the spread has since improved to +0.26%.
Have a great Sunday!