Throughout the long economic recovery since the financial crisis of 2008, economists and investors have waited for financial conditions to get back to “normal.”
But the list of trends that keeps confounding the experts is long. With unemployment at a 50-year low, wage growth should be stronger; home prices can’t keep rising faster than consumer inflation; and, perhaps most importantly, bond yields can’t remain low forever.
And yet a decade into the expansion, the benchmark U.S. government bond is now yielding 1.74% /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y -2.18% , a level that would traditionally signal crisis conditions in the economy.
The latest pundit to issue a public warning that such conditions can’t last forever is the former president of the New York Federal Reserve, William Dudley. “Low Treasury bond yields are not sustainable,” he argued in a recent op-ed for Bloomberg News .
“As I see it, the potential for a significant rise in long-dated Treasury yields is high,” Dudley continued. He outlines two reasons, one of which is that the level is just so low, there’s almost nowhere to go but up.
The second is that “term premia” should soon start to rise. That means that at some point, normal patterns of supply and demand and investor behavior should reassert themselves in the bond market, and longer-dated bonds should command higher yields. For one thing, investors should take note of the fact that the U.S. Treasury is issuing unprecedented amounts of debt to fund a trillion-dollar federal budget deficit.
Dudley also points out a lingering concern: the large amount of corporate debt outstanding, especially for lower-quality borrowers. “In recent years, U.S. corporations have taken advantage of low interest rates and narrow corporate credit spreads to increase their leverage and move down the credit-quality curve,” he wrote.
“We’re somewhat skeptical of Dudley’s view,” said Neil Dutta, head of economics at research shop Renaissance Macro.
Perhaps most importantly, “A number of other factors have offset the impact” of the excess supply of U.S. government debt, Dutta noted. Among them: jittery geopolitical and financial conditions have kept investors flocking to the safest assets, and as the Federal Reserve lowers short-term interest rates, it keeps a cap on yields of all maturities. And finally, the share of foreign purchases of U.S. Treasurys has remained constant, especially as sovereign bonds overseas carry negative interest yields.
What’s more, Dutta pointed out, upward pressure on inflation “is a good thing, not a bad thing. If growth and inflation expectations turn up, putting upward pressure on interest rates, we would expect the move to be accompanied by a drop in the equity risk premium and an increase in corporate earnings expectations. That’s not exactly the worst environment for equities or other risk assets like corporate credit.”