3% ISN´T THE MOST IMPORTANT NUMBER IN THE BOND MARKET / THE WALL STREET JOURNAL

3% Isn’t the Most Important Number in the Bond Market

The 10-year Treasury yield hitting 3% underscores a healthy economy that should put the stock market in a sweet spot

By Justin Lahart
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The real action has been driven by expectations the Federal Reserve will keep raising interest rates, which has pushed the 2-year yield to 2.47% from 1.89% this year. Photo: Joshua Roberts/Bloomberg News


The bond market is getting very exciting because the yield on the 10-year Treasury has finally crossed 3%. And while 3% is just a number, it is an important marker for the rise in long-term rates, which weigh on the economy. The 10-year yielded 2.41% at the start of the year.


The march higher in yields comes at an odd time, since the recent economic news hasn’t been great. But inflation does appear to be firming, and the rise in oil prices suggests the global economy is running a bit warmer.

Investors who are focused on 3% are missing the more important development in the market. The real action has been driven by expectations the Federal Reserve will keep raising interest rates, which has pushed the 2-year yield to 2.47% from 1.89% this year. As a result, the yield curve, or the difference between the yields on the 10-year and 2-year notes, has narrowed to just 0.5 percentage point.





That is a good spot to be. Healthy economic growth will keep the Fed on track to raise rates further, while modest inflation will keep long-term yields from spiking. This flattening of the yield curve makes people worried because the market gets closer to the dreaded inverted yield curve, meaning the 2-year yield rises above the 10-year. An inverted yield curve has often predicted a recession.





INVERSION AVERSION
S&P 500 12-month performance, by the spread between the 2-year and 10-yearTreasury yields*

Source: WSJ Market Data Group (S&P 500); Treasury Department (spread)
*The 10-year Treasury yield minus 2-year yield at the beginning of the 12-month period

We aren’t there yet. The current curve is still positive, which suggests bond investors believe the economy will be able to absorb Fed rate increases. An inverted curve, on the other hand suggests they believe the Fed has raised rates to the point where the economy risks faltering, and the central bank will need to cut rates in an attempt to head off a recession.

Rich Bernstein of Richard Bernstein Advisors says the way to think of the yield curve isn’t as a dimmer switch, but as an on-off switch—off is when the yield curve inverts. There is no reason to worry until switch gets thrown, and there is no big rush to get out when that happens. Stocks have tended to perform well when the yield curve is relatively flat. Since 1976 when the difference between the 10-year and 2-year yields has been between 0 and 0.5 percentage point, the S&P 500 has gained 13%, on average, over the following year.

When the curve has inverted, the S&P has gained just 5%, on average, and experienced some of its most harrowing declines. That counts as a cautionary message, but the Treasury market isn’t declaring last call yet.