The 10-year Treasury yield increased by 1.5 percent (or 150 basis points) in half a year. This looks a lot at first glance. But from a chartist’s perspective, the yield had been within the range of 3.3 percent to 4.3 percent for a year (from 9/2022 to 8/2023) and only broke through until last month. The so-called additional tightening is probably only 0.5 percent (or 50 basis points), not to mention it could come down later (at the time of writing, the yield was only 4.6 percent). It is too early to claim that the long-tenor Treasury yield has brought enough tightening.
Recently, a Federal Reserve governor claimed such a yield surge has already done the rate hike job. Certainly, not all governors share this view, especially those with voting rights. Such a claim is not wrong in that the overall financing cost is not only determined by the shortest tenor interest rate, which is controlled by policy rate, but is also affected by long-tenor yield. Intuitively, the short-term small loans benchmark is to the former, while the long-term larger debts benchmark is to the latter.
Smaller bank loans are the main funding channel for small or medium enterprises or individuals (households), while debt issuance is usually the giant corporates’ mode of finance. While the former are small in size, such loans are common, whereas the latter are big but small in number. Small loans could, therefore, make up more of the loan amount. Thus, whether the rise of short or long-tenor interest rates impacts inflation more is ultimately an empirical question because this depends on the size distribution of firms. Moreover, the interest rate also affects the economy not only by way of investment but through consumption.
The aggregate impact of such a complicated scenario is best seen by a variable such as GDP growth. Nevertheless, short and long-term interest rates could affect each other, and these interest rates have bilateral causal relationships with aggregate output. Whether the true causality of aggregate output is from the short or long-tenor interest rate is unknown unless the study is done via a (regression) model. We are not going to do this here, so bear in mind the following result is more descriptive than explanatory. Caution is needed in its interpretation.
Gather the 10-year Treasury yield and Fed funds rate, then average them into quarterly frequency and compute the year-over-year (YoY) change, from the start of YoY data in 1963. Comparing these with the U.S. real GDP YoY growth, the most negative correlations happen when GDP growth lags behind both interest rates by five quarters. Plot this on a chart as shown below. The relationships are indeed shown to be negative. The slopes are comparable, and it makes little sense to examine the difference further given that other factors are not controlled.
One might attempt to conclude that the impact of short or long-tenor interest rates is similar. Yet if the Fed resists hiking further, paradoxically, the long-tenor yield might revert to a lower level offsetting the tightening effect.
KC Law, Ka Chung
