Blog - Investing Notes

January 10, 2006 – T-note Yield Conundrum Weakening the Fed Model?

The 10-year Treasury note (T-note) yield is a critical input to most versions of the Fed Model of the stock market. It's recent resistance to rising is also one aspect of Alan Greenspan's bond conundrum. Since mid-2004, the Federal Reserve Board has raised the Federal Funds Rate more than a dozen times. Budget and trade deficits have continued to grow, suggesting inflationary pressures that may force additional rate hikes in the future. The T-note yield has gone nowhere. Is its misbehavior a random fluctuation? Do T-note buyers perceive deflation? Are expanding foreign holdings of dollars seeking save haven? Using annual (1962-2005) and monthly (1992-2005) data on the T-note yield, the 90-day Treasury bill (T-bill) yield, the inflation rate and the trade deficit, we find that:

The following chart depicts the T-note conundrum, comparing the paths of the federal funds rate, the T-bill yield and the T-note yield since the Federal Reserve began raising rates in mid-2004. The graph shows that the federal funds rate and T-bill yield are interlocked, while the T-note yield is oblivious.

Next we assess the plausibility of some possible causes of the conundrum, from both long-term and short-term perspectives. How much of a connection between the T-note yield and the T-bill yield is normal? The following two scatter plots for year-end values for 1962-2005 and month-end values for 1/92-12/05 (highlighting most recent data in red), with Pearson correlations of 86% and 67% respectively, indicate a fairly strong relationship. The average yield spread for longer-term year-end (shorter-term month-end) values is 1.33% (1.87%). The most recent short-term data (red circles on the second plot) show the insensitivity of the T-note yield to the T-bill yield.

Might buyers relate the T-note yield more to the inflation rate than to the T-bill yield, making purchase decisions based on current real yields? The next two scatter plots for year-end values for 1962-2004 and month-end values for 1/92-11/05 (highlighting most recent data in red), with Pearson correlations of 68% and 24% respectively, indicate some relationship. The average yield spread for longer-term year-end (shorter-term month-end) values is 2.66% (2.98%). The most recent short-term data (red circles on the second plot) shows that the inflation rate has not been extreme and that the T-note yield has been insensitive to inflation, suggesting that inflation anomalies are not the cause of the conundrum.

Are T-note buyers extremely astute investors, somehow foreseeing the long-term inflation rate (and currently foreseeing much lower inflation)? The next scatter plot compares year-end T-note yields with average inflation rates over the subsequent ten years for the period 1962-1995. The Pearson correlation between these two series is -1%, indicating no relationship and suggesting that T-note buyers cannot predict long-term inflation.

Are foreigners recycling dollars from record trade deficits into T-notes for safety or political reasons, thereby pinning the T-note yield at a low level? The next two scatter plots for year-end values for 1962-2004 and month-end values for 1/92-11/05 (highlighting most recent data in red), with Pearson correlations of 32% and 79% respectively, indicate some relationship. These charts do suggest that the larger the trade deficit, the lower the T-note yield. However, the correlations here are unstable. For example, for the longer-term data (upper chart), the correlation before the extremely high deficits of 1999-2005 is -16%. For the shorter-term data (lower chart), the correlation after 2001 is only 19%. It may be that the relationship is non-linear and/or has thresholds for significance.

In summary, foreign recycling of dollars from the extremely large current trade deficit into a safe haven may be the force holding down the T-note yield, but the most plausible expectation is that the gap between T-note and T-bill yields will normalize.

The long-term bond conundrum may be throwing the Fed Model out of whack. Our Real Earnings Yield Model, which pegs the stock market earnings yield to the inflation rate rather than the T-note yield, does not suffer from this conundrum.

For a collection of recent research related to the Fed Model, see Blog Synthesis: Gunning for the Fed Model?.