One of the big stories of June has been the jump in the 10-year Treasury yield which began the month at 4.89%, spiked as high as 5.30% at mid-month and closed yesterday at 5.10%. The month's end-of-day average so far is 5.12%, which compared against May's average of 4.75% would make the June-to-May change the fifth largest monthly increase of the last 10 years. In contrast, the yield on the 2-year note has actually declined by several basis points, starting the month at 4.92% and ending today at 4.89%. The rise in the 10-year note yield and its implications for the economic outlook are certain to be discussed at this week's FOMC meeting.

The 10-year note, the most liquid note in the long end of the Treasury yield curve, provides the basis for many loan rates including business loans and home loans. This Short Take will focus on the upswing in the 10-year yield and its implications for both economic growth and the financial markets.

Let's first look at why the 10-year yield has taken off. Strong economic growth -- both global and domestic -- is at the center. The month began with greater-than-expected non-farm payroll growth of 157,000 and a stubbornly low 4.5% unemployment rate. The two ISM reports on June 1 and June 5 were also surprisingly strong pointing to new momentum in the manufacturing sector and rising momentum in the non-manufacturing sector.

But it wasn't until June 6 when the Bank of New Zealand raised rates that the 10-year yield began to spike. New Zealand's action seemed to wake everyone up to the new balance of risks for Federal Reserve policy: that a rate hike, not a cut, could be the next change in policy.

In an aside, day-to-day information like that which appears here can be easily researched on Econoday's online calendar. Economic data and commentary are fixed and permanent, and each day includes a quick summation of activity and prices in "Market Reflections." The data are available not just for each day in June -- but for each day of the whole year and each day of prior years.

Inflation and the trouble with growth

Strong economic growth raises the risk that businesses will have to bid up wages to keep workers and attract new workers, raising inflation expectations that the Federal Reserve is committed to guard against. The longer a note's maturity, the more it's exposed to the erosion of inflation, which offers an explanation at least in part for the greater increase in the 10-year yield compared to the 2-year yield. Interestingly inflation data this month have been pretty tame, and thank goodness! If core consumer inflation at mid-month had been anything but tame, which it pretty much was at a 2.2% year-on-year rate, the 10-year yield would be posting an even greater, if not much greater, month-to-month increase. 

Taking a look at the graph above, the average rate of 5.12% would just nudge out the 5.11% averages of May and June last year. Note that the upswing in early 2006 from the mid 4% level preceded what turned out to be significant economic slowing through the second half of last year and the first quarter of this year. This slowing was centered in the housing market and raises the serious question whether the current spike will lead to new slowing in the housing market.

Increases in the 10-year rate in mid-2003 and early 2004 seemed at least in appearance to do little to slow housing starts in the above graph. But the extended 100 basis point rise from 4% in mid 2005 to 5% in mid 2006 is definitely followed by a slowdown in starts. One of the key things to keep an eye on is whether housing can find its feet given the new rise in rates which is hitting at the same time that mortgage lending standards, due to sub-prime excesses, have tightened. Hindsight now suggests that housing starts were kept strong over the 2004 to early 2006 period not just by healthy employment and income growth but also by loosened lending standards and increased use of variable and interest only loans. Graphs for other housing data including new home sales and existing home sales look pretty much the same.

Vehicle sales, the above graph, have shown less variation over the expansion, with year-on-year changes narrower than in housing and the annual rate pretty much stable at 16 to 17 million. Auto financing is based on shorter maturities but still the general rise in interest rates has cut into growth rates since 2006. Also note that a dip in rates in mid 2005 gave a brief boost to sales.

Higher yields have not had a dramatic effect on total retail sales, which have been rising pretty much consistently through the expansion. Many other factors besides interest rates come into play for total retail sales, especially the health of the labor market. But the graph above does show slowing rates of growth that are no doubt tied at least in part to higher borrowing costs.

Now let's turn quickly to financial readings. Increases in interest rates often attract foreign capital which is seeking higher returns. But global interest rates, highlighted for instance by the Bank of New Zealand's hike, are also on the rise and in many cases are rising faster and are at higher levels than domestic rates. The graph above, which compares the 10-year rate with the broadest exchange rate value, shows little effect from the 2006 increase in rates. The spike now underway has in fact had little effect on the dollar which so far this month is virtually unchanged against the euro.       

Increases in interest rates are a negative for the stock market as higher borrowing costs increase business costs, slow business development and slow profits. A look at the graph above shows the effect on the Wilshire 5000, the broadest measure of the stock market. Nevertheless, the stock market has been moving steadily forward.

Bottom line

The biggest effect of the 10-year spike may be on the psychology of the bond market. Going into the month there were no expectations for the 10-year to climb to 5.50%, a level that at mid-month some in the market were conceding as an immediate risk. By late in the month those worries have been forgotten. The bond market is a very important market but perhaps in this case its effects on other markets, and on the economic expansion, may be limited. But one thing the current spike may be hinting at, and we'll end with is, is an increase in the Federal funds rate.