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The yield on Treasury bonds is largely determined by the fundamentals of the economic outlook. As Guy LeBas, chief fixed income strategist at financial services firm Janney Montgomery Scott, told US News and World Report in May, “Treasury yields are correlated with economic conditions. Better economic prospects imply higher yields.” Low yields mean that wary investors are plunging their money into low-risk, low-reward investments rather than more risky assets such as stocks that have significantly higher rates of return.
During the massive expansion of the US economy that was facilitated by the pro-growth policies of President Ronald Reagan, Treasury yields persisted at high levels. The yield on the benchmark 10-year note hovered around 10-11 percent for the first two to three years of the Reagan recovery and registered at 8-9 percent for the remainder of the Reagan presidency.
Treasury yields under President Obama, however, have been drastically lower. Throughout a period marked by economic uncertainty, yields on 10-year Treasuries have remained below 4 percent for all but one day of Obama’s presidency. The worst figures for Treasury yields have come in the immediate past. On July 25, the yield on a 10-year Treasury note dropped to 1.43 percent, the lowest rate in recorded history.
Yields on 10-year Treasury Inflation-Protected Securities (TIPS) also indicate a bleak outlook. Data on TIPS yields is not available for years prior to 2003, but the numbers over the course of the Obama administration tell a clear story. TIPS yields have hovered at low levels throughout President Obama’s tenure; they dropped below zero early in 2012 and have continued falling all the way to a record-low -0.69 percent on July 31. This means that investors are essentially locking in a loss because they lack confidence in the economy’s future.
Over the long term, one variable that predicts the future performance of the economy is the yield spread between the yield on a 10-year Treasury note and the yield for a 3-month note. A smaller spread means the economy is more likely to grow at a slower pace or contract in the future. In a 1990s paper entitled “Predicting Real Growth Using the Yield Curve,” Economists Joseph Haumbry and Ann Dombrowsky wrote, “A decline in the growth of real GDP is usually preceded by a decrease in the yield spread, and a narrowing yield spread often signals a decrease in real GDP growth.”
An analysis that includes more recent data shows that the yield spread and real GDP growth remain very much related. Figures from 1982-2011 show that when the yield spread is lagged by six quarters, it is correlated in a statistically significant way with annual growth in real GDP. While the economy expanded at annual rates greater than 4 percent in 1983-1985 under President Reagan, real GDP grew by only 2.4 percent in 2010 and 1.8 percent in 2011. Moreover, the yield spread has fallen over each of the past five quarters and the linear model predicts real annual GDP growth of below 3.5 percent in 2012 and 2013.
While general pessimism about the long-term domestic economy is crucial in explaining the historically low yields on Treasuries, a lack of confidence in Europe’s economic situation is also a huge factor. Observers of financial markets from CNBC to the Wall Street Journal have blamed the unusual yield curve on a lack of progress in the resolution of Europe’s sovereign debt crisis. Forbes writes, “Investors afraid the European Union might unravel, after Spanish bond yields spiked and talk of a Greek exit returned to the table, fled for the apparent safety of U.S. government debt.”
Yet President Obama fails to heed the lessons of infinitesimal Treasury yields: massive spending is unsustainable. As profligate European nations such as Greece and Spain become insolvent and threaten the continued existence of a unified European currency, investors look to US government debt for security. Yet if the federal continues spending irresponsibly as it has with President Obama at the helm, US government debt will cease to be a safe investment and the federal government will be unable to borrow at low rates. At that point, bondholders would impose austerity, which would be extremely painful for taxpayers.
While it is true that events in Europe are largely out of the control of America’s policymakers, there are steps that can be taken, most importantly the immediate extension of the Bush tax rates, to inject confidence into the economy. It remains to be seen whether President Obama will learn from his mistakes and reverse the growth-smothering policies that have led to a historically bleak economic outlook.
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