MainStreet Macro: What’s all the fuss about?

This week on Main Street Macro, let’s take a figurative field trip to Wall Street, to a specific neighborhood called the Bond Market. 

While Wall Street isn’t the economy, there are times when the beliefs and actions of stock and bond traders affect Main Street business. 

Last week was one of those times.  Long-term bond yields, the return investors receive from debt securities, have been creeping upwards, causing many of our friends on Wall Street to catch the jitters.

What’s all the fuss about? Here are four things Main Street needs to know about the recent rise in bond yields.

Bond yields are rising from historic lows. For the past decade, the yield on the closely watched 10-year Treasury bond averaged a bit over 2%. Look back further, however, over the last 50 years, and that yield has been much higher — closer to 6%. 

The onslaught of the pandemic pushed the 10-year bond yield to record lows, well below 1 percent. More recently, it has climbed back closer to where it was a year ago, before the coronavirus pandemic hit. 

The increase in yield has triggered hand-wringing on Wall Street. Investors worry that rising yields could slow or reverse the dramatic and remarkably persistent climb of equity prices over the past 10 months.

From the cheap seats, Wall Street’s angst seems a little overdone. When interest rates rise from low levels like we have now, the stock market generally goes up. It’s only when interest rates rise from high levels do stock prices fall. When adjusted for inflation, real yields on long-term bonds are actually below zero (that’s low, folks).

Source: St. Louis Federal Reserve Economic Research

Yields are rising for the right reasons: In testimony before Congress last week, Federal Reserve Chair Jay Powell said rising bond yields were a sign of Wall Street confidence in the economic recovery.

Wall Street has a lot to be confident about–the prospect of more stimulus, a pickup in the vaccine rollout, and a surge in consumer spending when the economy fully opens.

All point to faster economic growth later this year. But faster growth could lead the Fed to pull back on the super-cheap money it’s been supplying to the markets since the onslaught of COVID-19. Wall Street wants to have its cake and eat it too. It wants faster economic growth and continued monetary stimulus and the icing on the cake — more fiscal stimulus.

For monetary policy, this time is different. Generally, when the economic outlook improves significantly after a downturn, the Fed responds by increasing short-term rates to ward off the risk of inflation that typically accompanies faster growth.

This time is different.  Wall Street’s favorite equity cash cow (the near-zero rates we’re talking about) won’t be put to pasture anytime soon. Last week, Powell reassured the markets that the Fed plans to keep rates at current low levels until the jobs market has recovered fully, even if inflation rises modestly.

Rising rates make borrowing more expensive: Bond yields translate into interest rates which affect borrowing costs for everyone, from Joe’s Pizzeria to Fortune 500 companies like ADP to my next-door neighbor with the dog that barks at 3 a.m. (I digress).

Most consumer loans are benchmarked to the 10-year Treasury bond. So rising yields mean higher mortgage rates and costlier car loans, which could curb consumer enthusiasm for big-ticket items.

It also means pricier borrowing for Main Street companies. Small companies aren’t able to raise funds on Wall Street at near-zero levels the way big companies can.  They rely mainly on costlier bank loans, more like consumers.

On the flip side, when the gap between short-term rates (like the interest rate earned on your savings account) and long-term rates (like the rate on your mortgage) is wide, lending to Main Street becomes more profitable.

On Wall Street jargon, they call this gap a steepening yield curve.  And the wider the gap — or the steeper the curve — the more money banks are willing to lend to a wider swath of creditworthy borrowers.

Currently, that gap is steepening with a pickup in long-term rates, while the Federal Reserve holds short-term rates at ultra-low levels. In this type of interest rate environment, credit to small businesses is more likely to increase, accelerating rather than dampening economic growth.

My Take

Wall Street has been fixated on rising bond yields and whether the end of super-cheap money will affect stocks’ performance in the near term.

This Main Street Economist takes another view. With 10 million workers still sidelined by the pandemic, it’s employment gaps, not borrowing costs, that could slow the economic recovery.

The three-month moving average of job creation is 29,000 per month, far short of what we need to see an employment recovery in the next five years.

Even if bond yields edge all the way up to recent historical norms, they’re still low. Lower rates are here to stay for a while longer.

Rising rates might be jarring for Wall Street, but rates that rise because the economic outlook has brightened could be a winning trade on Main Street.