Fearful Symmetry: Six Decades of Treasury Yields
Wednesday, April 4, 2012
Interest rates are the price put on the future. The market in U.S. Treasury debt securities is by far the largest market in the world, and the largest in history, for securities of homogeneous credit risk. It is very actively traded, liquid, and highly efficient.
Yet interest rates in this market over time display surprising behavior—indeed, behavior that previous market participants considered simply impossible. This history is an object lesson in how at each phase of the present, we know little of the future.
Consider the remarkable path of yields on 10-year U.S. Treasury notes from 1950 to March, 2012 (see graph below)—the long period of first rising, then falling, interest rates.
First, look at the amazing symmetry! The chart begins in the first quarter of 1950, and ends 62 years later, with interest rates at the same level: about 2 ¼ percent. At the beginning and the end, the Federal Reserve was and is, respectively, manipulating bond prices to keep long-term interest rates low. In 1950, this manipulation had been going on since World War II. Naturally, we wonder how long it can go on now. The Treasury Department did and does greatly appreciate this help in keeping down its financing costs.
In the years in between, the chart makes an interest rate mountain. Ten-year Treasury rates peaked at over 15 percent in 1981—a level unbelievable in 1950 and again unbelievable now, but the reality in the aftermath of the runaway inflation of the 1970s. It was the death-knell of the savings and loan industry and of the postwar American mortgage finance system. From 1950 to 1981, there was a painful, secular bear market in bonds for three decades. Then came a secular bull market in bonds for three decades. The near mirror-image of the secular bear and bull decades is truly remarkable.
After this symmetrical rise and fall, how do we go about anticipating what is coming next?
An old colleague of mine worked on a strategic planning effort at a major American bank during the 1960s. Interest rates had been rising, so they asked themselves, “What is the highest U.S. interest rates could possibly go?” Their answer: 6 percent.
When Treasury rates did get to 6 percent in the late 1960s, one of my old bosses, who then was running a major bond department, told me they all said to each other, “Buy now, because we’ll never see 6 percent again!” Indeed, starting in 1972, they did not see it again for a very long time, but in the opposite way from what they thought. Rates did not go below 6 percent for over 20 years, until 1993. By then, everybody was convinced that a bond rate of 2 percent was impossible, having forgotten that it was once a reality.
The ability to anticipate what interest rates will do, even that of highly educated, trained, and experienced professionals, appears distinctly limited. “They had believed in 1946 that 2 ½ percent was a fair rate of interest at which to lend for the long run,” James Grant tells us in his usual sardonic style. “They had entertained similar delusions about 3 ½ percent in 1956, about 4 ½ percent in 1959, and about 5 ½ percent in 1966. When successive presidents, Treasury secretaries and Federal Reserve Board chairmen had promised balanced budgets, lower interest rates, and sound money, they had believed them. It was one of the longest losing streaks in the annals of investments.”
Ten-year Treasury rates peaked at over 15 percent in 1981—a level unbelievable in 1950 and again unbelievable now, but the reality in the aftermath of the runaway inflation of the 1970s.
Grant’s story continues: “In 1969, interest rates were higher than they had ever been before. The typical well-regarded utility was paying 9 percent. Since the time of Queen Anne [who reigned 1702-14], long term, investment-grade bond yields had rarely risen above 6 percent. Something was plainly awry.”
But they hadn’t seen anything yet. The United States reneged on its international commitment to redeem the dollar for gold in 1971. Then, as the Fed ran the printing presses during the 1970s, bond yields trended accordingly higher. Finally came the 1981 peak, with the Fed, under Chairman Paul Volcker, famously “breaking the back” of the inflation it had itself created. The great irony is that the Fed then took credit for saving us from the results of its own actions.
Now began the great secular bull market in bonds. On average, for the entire grown-up memory of people now in their thirties and forties, interest rates were on average falling. This made for one of the longest winning streaks in the annals of investments. From 1981 to 2011, according to Merrill Lynch, long-term bonds returned an average of over 11 percent per year. This is a record which won’t happen again for a long time. The latter part of this period of course includes having the Fed’s low interest rates encourage the housing bubble, the deflation of which crashed the American housing finance system once again.
At this point, not only are nominal interest rates low, but with inflation at 3 percent, the real (after-inflation) yield on the ten-year Treasury is significantly negative. If you think the Fed will get its 2 percent inflation desire on average, it means an investment in ten-year Treasury notes is locking up an essentially zero real yield for ten years. As a leading bond investor put it in 1912: “Nothing but unfamiliarity with investment principles is an excuse for private buying of United States bonds to net 2 ½ percent.” Surely something is awry.
Presidents, Treasury secretaries, and chairmen of the Federal Reserve Board no longer promise anything resembling balanced budgets or sound money. But the current Fed Chairman has promised low interest rates. How great an irony will this promise represent for future bankers, if they remember it, and future financial historians?
“In the charts and tables of interest rates over long periods,” wrote the classic chronicler of interest rates, Sidney Homer, “students of history may see mirrored the rise and fall of nations and civilizations, the exertions and tragedies of war, and the enjoyments and abuses of peace … the fluctuations [in] the progress of knowledge and technology, the successes and failures of political forms.”
Doubtless future interest rates will continue to be as instructive, and as capable of surprising us and frustrating our expectations.
Alex J. Pollock is a resident fellow at the American Enterprise Institute.
FURTHER READING: Pollock also writes “There’s Usually a Banking Crisis Somewhere!” “Smart Will Never Mean 'Not Wrong',” “Make the Treasury Responsible for 'Unofficial Debt',” “National Debt Is Larger, More Subtle Than Thought,” “Waiting for Hamilton: The ‘Imbecility’ of the EU,” “Fixing Student Loans: Let’s Give Colleges Some ‘Skin in the Game’,” and “Elastic Currency, With a Vengeance.”
Image by Darren Wamboldt/Bergman Group.