Goldman's Jim O'Neill On The Consequences Of The 10 Year Hitting 5%

Here's a hint: it's all great. Just like the 10 Year hitting 0% was great for stocks, Jim explains why its round trip bacl to 5% is even gooder. In fact, it may be one of the goodest things to ever happen to the gnome underpants business that Goldman suddenly believes the US economy is: "I would guess that GDP growth could be above 3 pct, and it would not surprise me if some start forecasting close to 4 pct soon...checking my simple stats with Jan Hatzius this weekend, the US stock market would “only” need to rise by around 19 pct in order for the 168 bps rise in government bond yields to be entirely neutralized...Are 5 pct US 10-year yields and an S+P of 1475 possible in 2011? We shall see. In my opinion, a 19 pct rise in the US stock market seems quite likely. As for 5 pct bond yields, I think they are much less likely, but not impossible. If they did occur, it certainly wouldn’t have to be for negative reasons." That's all fine and great even if it is totally and utterly insane. The real win here, and it may be hidden at first, is that we now have not a phrase, but an entire essay to challenge that all time dumbest thing ever uttered: "If it weren't for my horse, I wouldn't have spent that year in college"...

From Goldman Sachs Asset Management:


In the past two weeks, we have witnessed a remarkable rise in US interest rates. Those people who are one step removed from the financial markets might not be really notice, however, since the level of interest rates is still remarkably low. But, in the past 2 weeks, the rise across the whole maturity spectrum of US rates has been quite noteworthy. The topic was discussed by John Authers in Saturday’s Financial Times. According to John, 10-year rates rose 14 pct on Tuesday. And, since their absolute bottom on October 7th, they have risen 37 pct. As I shall discuss below, this rise has led to numerous discussions, many of which suggest that the Fed’s so-called “QE2” has not worked. Others suggest that this rise is the work of bond market vigilantes punishing the US ala European style for fiscal excess, and a small number acknowledge, in fact, that it simply recognizes that the US economy is suddenly looking quite a bit perkier. The latter argument is my own preferred one. More on this later, but the fact that shorter term interest rates have risen sharply in my judgment supports this view.

US 2-year note yields have risen from around 0.38 basis points (bps) to around 0.64 on Friday – a near 70 pct increase! Presumably, this part of the yield curve is less vulnerable to pure market forces and more closely related to perceptions of central bank policy over the next 2 years. If this is correct, then I can’t understand why the more negative assessments of rising rates are appropriate.


Of course, none of us really know or never will. There appears to be 4 possible explanations. First, the most abrupt rise happened last week, coinciding with signs of an agreement between President Obama and Congress for an additional fiscal stimulus. Given the underlying fiscal deficit and debt situation, which on a cyclically-adjusted basis appears to be on a par with Portugal, the bears are arguing that the vigilantes are suddenly out in force, expressing their distaste for the wanton disregard of any kind of budgetary discipline in the world’s largest economy and major reserve currency. While this is certainly possible, I am far from sure that it is the case. If it were true, how come the Dollar rose during this period, and US stock indices continue to make fresh highs?

Second, some bears also argue that, possibly related to the first point, it is the beginning of an inflationary surge in the US and the appropriate punishment for the lavish monetary and fiscal stimulus that has been applied to help exit from the severe recession induced by the housing collapse and credit crisis. This seems even easier to refute in my view, as much of the rise in yields can also be seen in “real yields” through the TIPS market, and most measures of inflationary expectations have been quite stable.

A third argument, also possibly linked to the others, is that it is simply recognition that, whatever the state of the economy, there will be no more quantitative easing given the hostility in which QE2 was greeted, both by many politicians domestically and by overseas policymakers. While it is probably the case that the Fed is somewhat surprised by the strength of opposition expressed to their move, my view is that the Fed will judge their future monetary policy needs and obligations by both the actual evidence and outlook for real economic growth, employment and inflation.

The final fourth and quite simple argument is that, “It’s the economy, stupid.” In the past few weeks, with the exception of the November payrolls, most important coincident and lead indicators for the US have improved notably. Of most importance, there has been a sharp improvement in weekly jobless claims, a good guide to underlying unemployment and a pretty good predictor of the stock market. The November manufacturing ISM survey kept hold to much of its previous monthly outsized gains and, towards the end of last week, the October trade report showed a further sharp improvement in exports. If you add the possible 0.5-1.0 pct stimulatory impact of the budget deal, it is looking more and more likely to me that 2011 is going to be an “above trend” year for US real GDP growth. I would guess that GDP growth could be above 3 pct, and it would not surprise me if some start forecasting close to 4 pct soon.

If the latter explanation is conceivable, then this would sit more easily with what has happened to all financial markets, including the stock and foreign exchange market.

I have thought since late September that it was quite possible, even likely, that once the mid-term elections were out of the way, the negative mood surrounding the US might lift. Indeed, I have joked on a number of occasions that everyone I met seemed to think that they had a below consensus view of the US economy. Well, this is no longer the case. And, for those that stick with a negative cyclical outlook, they have got to be hoping that rising US interest rates choke off the budding recovery.


I have 2 completely contrary opinions.

The first, and the one I am assuming, is that in the near term, US rates will not rise much further. I had thought back in September when I first smelled signs of stronger US growth than generally perceived, that if the data started to back me up, then it would be likely that the case for QE3, i.e., even more Fed easing would quickly fade and the US 2-year note sometime in Q1 2011 would get to 0.75. That is now only 11 basis points away, a mere 17 pct! I assumed that 10-year yields might manage 3.50 pct, a mere 18 bps and now just 5 pct away.

If the Fed is conducting policy on what might be referred to as an “output gap” basis, then it is going to take a lot more positive growth before the Fed gives up its recent concerns and those stated reasons which led it into its last monetary easing. While the view will vary depending on individual assumptions of the growth trend, some key Fed officials like Bill Dudley have used phrases like “many years” in describing how long the Fed might have to stick to its current policies.

For the 2-year note to move up to 1 pct and beyond, I think the Fed will need evidence of 5 pct real GDP growth for 2011 before that were warranted. Of course, this strength of GDP growth is not impossible and the next month’s ISM and payroll data are likely to be highly illuminating.

If 2-year notes don’t move much above 0.75 pct, it is tough to see 10-year yields rising much above 3.50 pct unless the darker interpretations from above were the main culprit, i.e., fiscal profligacy and sharply rising inflation expectations.

The second opinion is very different.

Within a couple of weeks of my move into this new exciting phase of my life, I started to spend quite a lot of time wondering about the “consequences” of 5 pct 10-year US bond yields. There are many reasons why this came into my head including that, at some stage in the future, if the US economy returned to normal health, 5 pct would be the likely 10-year yield. Such a future might be described by inflation returning to 2 pct and a more normal growth cycle, which would vary around the trend growth rate somewhere between 2.5-3 pct. Adding a small risk premium, such an environment would be broadly consistent with US bond yields at 5 pct.

I now find myself thinking that if these thoughts go through my mind, then the same is likely to be true for many others when they start to believe that the US economy might be returning to normality. It is conceivable that this could happen in 2011, especially if the US and other companies around the world starting spending their large cash holdings and banks return to lending.


Surprise surprise, none of us know that either. But let me take a stab.

For all the bears that think it could only occur because of the irresponsibility of US fiscal policy and rising inflation, and others that probably believe a rise to 5 pct bond yields would lead to another recession, the key way of thinking about the issue is in terms of US financial conditions.

In the GS Economics Department’s US Financial Conditions Index (FCI), a close proxy for10-year bond corporate bond yields have a weight of 55 bps. It is probably the case that a 168 bps rise in 10-year government bond yields would have a significant impact on the FCI, although it is possible that corporate–government bond spreads would narrow. The direct impact, if the FCI used only government bond yields, would be just over 90 bps.

What would happen to the overall US FCI would then depend on the other 45 pct, made up primarily of short-term interest rates, the trade-weighted Dollar, and an index related to the stock market.

If the bears were right, and such a rise is really because of the state of US fiscal affairs, then the Dollar might fall and corporate bond spreads tighten, which would offset some of the 90 plus bps tightening. A decline in the equity market would tighten conditions further. Such a move of the FCI would itself, in turn, dampen the longevity of any sharp US recovery.

If the optimists were right, and if any rise in US bond yields continued because of a return to normality, then in fact, the Dollar might rise, corporate bond spreads certainly tighten, and the stock market rally, possibly significantly. In fact, checking my simple stats with Jan Hatzius this weekend, the US stock market would “only” need to rise by around 19 pct in order for the 168 bps rise in government bond yields to be entirely neutralized.

Are 5 pct US 10-year yields and an S+P of 1475 possible in 2011? We shall see. In my opinion, a 19 pct rise in the US stock market seems quite likely. As for 5 pct bond yields, I think they are much less likely, but not impossible. If they did occur, it certainly wouldn’t have to be for negative reasons.


This is a topic for a separate piece. But, in my judgment, among reasons why it wouldn’t entirely be a bad thing are the two great debates surrounding the future of the monetary system, and separately the true strength of conviction about US$ based capital moving into so-called “emerging markets.” A few things seem clear to me:

1. The Dollar would strengthen somewhat, especially against the Yen. All comparisons with Japan’s lost two decades would rightly diminish.

2. The problems of European Monetary Union would appear relatively starker, although a stronger US economy combined with the strength of the BRIC countries would be good for European growth.

3. World GDP growth might exceed 5 pct for a while.

4. Money would leave emerging markets by those that treat them as old fashioned emerging markets, leaving the table more open for those that rightly regard a lot of those countries, especially the bigger ones, as “Growth Markets.”

5. More money might flow from debt to equity in the EM/Growth World, rather than back to the more developed markets.

Much to look forward to, not the least of which is the coming holidays and all that exciting football in the next fortnight!
Jim O’Neill

Chairman, Goldman Sachs Asset Management

in other words:



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