In a pre-D-Day invasion by bond bears, the yield on global bonds soared on what many claim was in reaction to ECB Chair Mario Draghi’s comments that markets “should get used to volatility,” combined with the better-than-expected U.S. jobs report for May. Global stocks also tumbled as investors wondered just how soon and how high interest rates would climb. Well, if history is any guide, for it’s never gospel, history says that at a 1.8% year-over-year gain in core CPI, Fed funds should be trading above 3% and the 10-year note above 4%.
The yield on the 10-year note is the premium investors pay for inflationary uncertainty over the coming 10 years. As the Fed funds rate rises, however, the threat of inflation becomes increasingly reduced. Therefore it is logical to think that the higher the Fed funds rate rises, the narrower the difference, or spread, between the yield on the 10-year note and Fed funds. History agrees. Since 1954, correlation between the Fed funds rate and the 10-year/Fed Funds differential (the 10-Year yield minus the Fed Funds rate) was -0.66, or a high frequency that whenever the Fed funds rate rose, the differential shrank, and vice versa.
The 10-year/Fed funds differential is currently 2.26 percentage points, which is significantly higher than the average of 1.05 points for all months since 1954, and will above the average 1.88-point spread whenever the Fed funds rate was below 3%. Therefore, even though both the Fed funds rate and the yield on the 10-year note will need to climb to get back to a more normal relationship to inflation, the differential rate will probably narrow as these rates return to equilibrium.