As the economy returns to growth, will Treasury yields rise?

Although the evidence is now quite strong that the global economy is slowly returning to growth, Treasury yields are unlikely to rise much as long as central banks maintain their current accommodative monetary policies.

Monday brought further evidence that economic activity in the euro area is rebounding. Eurostat reported that industrial new orders in the euro area rose 3.1 percent in June. Excluding ships, railway and aerospace equipment, which tend to be more volatile, industrial new orders grew by 1.9 percent.

Monday also provided further evidence that the United States economy is improving. The Chicago Fed National Activity Index rose to -0.74 in July from -1.82 in June. The three-month moving average rose to -1.69 from -2.18.

Despite the better data on the economy, US stocks were flat on Monday. The Standard & Poor's 500 Index fell 0.05 percent to 1,025.57.

Also downplaying the better economic data were US Treasuries, which rose on Monday. Two-year note yields fell eight basis points to 1.02 percent while 10-year note yields fell nine basis points to 3.48 percent.

Indeed, Macro Man noted in a blog post yesterday that bond yields have stayed subdued recently and are closer to their three-month lows than their three month highs. In contrast, the S&P 500 "is now at its highest level in ten months". Macro Man noted that since the onset of the crisis a couple of years ago, there had been "a pretty strong positive correlation between stock prices and bond yields", so the recent divergence represents a break from the previous pattern.

Macro Man acknowledged that one mitigating factor for the valuation of Treasuries has been the ongoing decline of LIBOR but still thinks that fair value for US 10-year yields is "well north of current levels".

However, I would be hesitant about making the same conclusion.

Today, we are witnessing an incipient economic recovery while monetary policy remains highly accommodative. Both of these conditions tend to drive stock prices up, which explains the strong performance of the S&P 500 recently. However, while an economic recovery also tends to drive bond yields up, easy monetary policy tends to keep yields down.

Therefore, considering the current economic conditions, it is probably too much to expect a tight correlation between stock prices and bond yields to be maintained throughout.

In fact, once you factor in the low federal funds rate set by the Federal Reserve, Treasury yields already look pretty high.

The accompanying chart shows how, over each of the years from 1955 to 2008, the change in the 10-year Treasury yield (shown on the vertical axis) has varied with the difference between the change in the federal funds rate and the spread between the 10-year yield and the federal funds rate at the beginning of each year (shown on the horizontal axis). The 12-month rise in the 10-year yield up to July 2009 is represented by the red square.

As can be seen from the chart, the 10-year yield has actually declined less over the past 12 months than would usually be the case based on changes in the federal funds rate and spreads alone. In other words, the market is apparently demanding a higher yield than it usually would, suggesting that it is already discounting other factors, including possibly an economic recovery or an increase in the supply of Treasuries. Whether these other factors are fully discounted is, of course, another matter.

The historical data represented in the chart show that the spread between the 10-year yield and the federal funds rate has a significant bearing on the future course of the former. Currently, the spread is over 300 basis points. Historically, such a high spread puts downward pressure on the 10-year yield.

The downward pressure on the yield would be mitigated if the market expects the federal funds rate to be raised, as it usually would in the face of an economic recovery. However, Federal Reserve officials, including Chairman Ben Bernanke, have remained cautious about the prospects of an economic recovery and mostly reiterated the view that the federal funds rate will remain low for some time to come.

This means that the federal funds rate is likely to continue to weigh on Treasury yields and limit the scope for the latter to rise in the coming months.

Having said that, Monday also saw another development -- one that could potentially be significant in determining the course of government bond yields over the coming quarters. The Bank of Israel announced that it is raising its interest rate for September by 0.25 percentage points to 0.75 percent. It is the first central bank to raise its interest rate since the global economic recession started showing signs of easing.

As long as the big central banks like the Federal Reserve and the European Central Bank maintain their current accommodative monetary stances, the BOI's action will have no significant impact on the rest of the world and global interest rates will remain low.

Still, the BOI's rate hike is the clearest sign yet that the trend of ever-falling central bank rates may have finally come to an end.