For the first time since March 2020, the yield on the 10-year U.S. Treasury has risen above 1%. Market participants are betting that the new administration will provide additional fiscal stimulus, possibly another $1 trillion. Jefferies Group LLC wrote that in addition to increasing inflationary pressures, this stimulus should add around two percentage points to economic growth over the next two years.

The interest costs on Treasuries has widespread ramifications because money does not grow on trees.

  • The borrowing costs on Treasuries influences the rates on mortgages and corporate bonds because creditors demand increased compensation for nonsovereign debt.
  • Investors weigh the potential but uncertain profit of stocks, cyber currencies and gold against the predictable return from fixed income. Today’s low interest rates make equities an attractive alternative to bonds, especially if their dividend payouts exceed bond yields.

Higher yields will require the Federal Reserve to intervene only if the move jeopardizes current easy (accommodative) financial conditions. That is, by keeping rates low, our central banks have encouraged companies to invest in new equipment and to hire more workers because their return on investment exceeds their costs of money. In a nutshell, low borrowing costs promotes risk taking.

Unless Fed officials see inflation exceeding significantly 2%, they will keep rates low. The Fed can employ many tools to promote their monetary policies.

In March, the financial markets almost totally froze up. During that month, the yield on the 10-year Treasury fell below .4% because of investor fear about the pandemic. We witnessed one of the most dramatic stock market crashes in history. In four days, the market dropped nearly 26%. The decline reflected the massive lockdown of our population and the shutdown of most of the manufacturing and service businesses. Hopefully, COVID-19 vaccinations will provide the real path to economic recovery.

Current interest rates by any measure are extremely low. During my career on Wall Street, 1969-2004, the 10-year Treasury yielded on average close to 7%. The precipitous decline in rates reflects historic changes that need to be examined. Inflation has averaged just over 1.5% over the past decade, well below the Federal Reserve’s target of 2%.

For many years, Federal Reserve officials accepted the market dictums of the Phillips Curve. In the 1950s, A.W. Phillips demonstrated the traditional short-run tradeoff between inflation and economic activity. Specifically, over time, low unemployment would boost inflation and high unemployment would lower inflation. Over the past decade, belief in the validity of the Phillips Curve has abated for reasons discussed in subsequent paragraphs.

Why is inflation so low? Since 2008, globalization and slow growth have curbed price increases. Globalization has increased linkages between countries. Cheap foreign goods and services undermine the pricing power of domestic sources who have lost their barriers to entry. The spread of global supply chains and declining unionization have reduced the ability of employees to bargain effectively.

The spread of the internet has changed patterns of commerce for millions of consumers and businesses, providing greater price transparency and more competition for local businesses, thereby limiting price increases.

Repeatedly, America’s most successful stock investor, Warren Buffett, has advocated purchasing stocks over bonds. While he does not forecast where interest rates are heading, he emphasizes that as long as interest rates remain low, the current stock market valuations are justified.

Well-run companies retain and reinvest earnings to grow businesses. Buffett points out that “combining savings with compound interest works wonders.” Returns from great companies are “truly mind-blowing when compared to the returns that many bond investors have accepted on bonds over the last decade.”

Buffett believes only in investing over a longtime period. “If you are not willing to own a stock for 10 years, don’t think about owning it for 10 minutes.”

Originally published in the Sarasota Herald-Tribune