Don't Worry, Be Happy: Falling Treasury Yields Edition

Long-term treasury interest rates are falling again with the 10-year treasury briefly dipping below 2% this week. Some observers see this decline in yields as an omen for the U.S. economy:

The United States economy is accelerating... Yet a huge bond market with a strong track record for predicting economic problems is flashing a warning sign right now.The prices of Treasury bonds are rallying fiercely. The slide in oil prices has elevated concerns about growth in the global economy, and investors, as they do in times of stress and uncertainty, are seeking out the safety of government bonds. 

The rally in global government debt is pushing their yields, which move in the opposite direction from their price, to astonishing lows... “Make no mistake, these low levels of rates are challenging the notion that we are going to see robust and constant growth,” said George Goncalves, a bond market analyst with Nomura. In other words, the bond market is raising the specter that a period of economic growth that may have already felt lackluster to many Americans could be on the verge of losing steam. 

So is this dire view of the falling interest warranted? I am not convinced that it is, but before I explain why it is worth noting that even monetary authorities are bewildered by it. According to the Wall Street Journal's Jon Hilsenrath (AKA the "Fed Wire"), Fed officials are not sure how to interpret what is going on with yields: 

Falling long-term interest rates pose a quandary for Federal Reserve officials... If falling yields are a reflection of diminishing inflation prospects, as is typically the case, it ought to prompt the Fed to hold off on raising short-term interest rates in the months ahead. If, on the other hand, lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner or more aggressively than planned. 

[...] 

The Fed’s next policy meeting is three weeks away. It is clear officials will spend a considerable time debating the correct response to a perplexing lurch down in long-term rates.

The worried market observers and the perplexed Fed officials should take a deep breath. The Adrian, Crump, and Moench (2013) method of decomposing treasury yields paints a far more benign story, one that signals the U.S. recovery is on a solid footing.

To see why, we first need to recall that long-term interest rates can be broken down as follows:

(1) long-term interest rate = average short-term interest rate expected over same horizon + term premium

The term premium is the added compensation investors require for the risk of holding long-term treasuries over short-term ones. For example, if investors are worried that the Eurozone crisis is about to flare up again and desire to hold more U.S. treasuries, they will demand less compensation to hold the long-term securities. This will drive down the term premium. The term premium is also the component of the long-term interest rate the Fed was trying to manipulate with its large-scale asset purchases. 

The other component, the average short-term interest rate, is a nominal interest rate and via the Fisher relationship can be further decomposed into a real interest rate and an expected inflation:

(2) long-term interest rate = (average expected real short-term interest rate over same horizon + average expected inflation over same horizon) +  term premium

This average expected real short-term interest rate is often called the real risk-free interest rate since it is free of investor's risk considerations, the Fed's tinkering with risk premiums, and the expected path of inflation. This interest rate measure, consequently, tracks the fundamentals of the economy and is equivalent to the average expected path of the 'natural interest rate'. 

By looking at these components we can make sense of what is driving the fall in yields. We can also look to the real risk-free interest to see what it implies about the health of the U.S. economy. The Adrian, Crump, and Moench (2013) decomposition of the 10-year treasury yield into these components is below:

What we see is that changes in inflation expectations and the term premium are both behind the decline in the 10-year treasury interest rate. This suggest that there may be concerns about future inflation--though this might also be reflect the temporary drop in inflation from declining oil prices--and that there has been a rush into treasuries because of the worries about the Eurozone and China.

But there is more. After being negative for several years, the real risk-free interest rate has been steadily climbing and is now positive. This only happens when the economic outlook improves as seen in the figure below. It shows a close relationship between the real risk-free interest rate and the business cycle:

So the upward trend of the real risk-free rate implies we are in the midst of a solid recovery in the United States. This interpretation is supported by the spate of positive economic news shows. Yes, the economic problems in Europe and China could eventually harm the U. S. economy.  But for now the U.S. economy seems to be in the clear. 

So be careful when interpreting long-term treasury yields. They might be signalling a robust recovery even if they are falling.