How High Are Interest Rates Heading?

10-year Treasury yields jumped in the first quarter from 0.92% to 1.75%, resulting in the worst quarterly performance for bonds in more than 40 years, explains Marvin Appel of Signalert Asset Management.

This month, yields have settled down to the 1.6% area even as inflation heats up. In deciding how to manage your bond investments it can be helpful to develop an interest rate outlook. In this article, I will review the multi-decade history of how interest rates compared to inflation and GDP growth to give you an idea of how overvalued bonds remain and what the upside potential for interest rates might be in the years ahead.

10-Year Treasury Note Yield and Inflation

The chart below shows the long-term history of real 10-year yields, which is the 10-year Treasury yield minus the trailing 12-month percentage change in the consumer price index. The historical average real yield has been 2.25%. That means that if the Federal Reserve manages to keep inflation at its 2% target, a historically typical yield on 10-year Treasury notes would be 4.25%.

However, real yields have varied widely. In the 1970s, real yields reached very negative levels as inflation spiked. The bond market’s reaction in the form of very high interest rates in the early 1980s generated a golden age for bond investors, with real yields well above average for most of the 1982-2003 period. However, since 2010 real yields have been paltry most of the time, particularly in 2020.

Assuming that we are in for a prolonged period of modest (but positive) real yields, say 1%, and that inflation does average 2%, it seems reasonable to expect 10-year Treasury yields to continue their climb until they reach at least 3%.

10-year Treasury Note Yields and GDP Growth

A widely cited rule of thumb is that the 10-year Treasury note yield is fairly valued when it is roughly equal to the rate of nominal GDP growth. The chart below shows how well GDP growth and Treasury yields have tracked each other. It has been the case that over multi-year time frames, GDP growth and yields have moved in parallel. However, GDP growth is much more volatile than interest rates, so the data in any given year are likely to be very divergent. 2020 is a prime example: GDP contracted but 10-year Treasury note yields remained above zero. In 2021 the economy is expected to grow by at least 8% (6% headline GDP growth projection plus 2% inflation), and of course 10-year Treasury yields are nowhere near 8%.

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