A relatively strong correlation exists between economic growth, inflation and 10-year Treasury yields as can be seen below (first graph). I believe the current leap in GDP growth is due to the economic reaction from reopening post pandemic; however, I think this is transitory. Take a look at the two trend lines in the second graph and read why I believe a return to the red line is more likely. The third graph shows how the employment situation is not strong, as there are almost 15 million people on some type of unemployment benefit. This lack of employment and wage growth along with all the debt (last graph and last week’s update) leads to limited spending and future GDP growth. As such, the 10-year Treasury yield should resume its descent.
Please proceed to The Details for a more in-depth analysis.
“Prefer knowledge to wealth, for the one is transitory, the other perpetual.”
The general consensus of financial pundits is GDP is about to soar leading to massive inflation and higher interest rates. The problem with this simplistic conclusion is it only factors in the short-term move in GDP beginning at the pandemic bottom and ignores the overarching structural obstacles. In my May 11 newsletter found here, I explain why I believe the recent inflation surge is likely to be transitory. In this missive, I further postulate that the leap in GDP growth is merely a short-term reaction resulting from reopening a shuttered economy. A return to longer-run low GDP growth and a drop in 10-year Treasury yields are also on the horizon.
A relatively strong correlation exists between economic growth, inflation and 10-year Treasury yields as can be seen in the graph below.
A little over two-thirds of economic activity is derived from consumer consumption expenditures. When the pandemic hit, consumption plummeted. Then, the Federal government jumped in and provided three rounds of pandemic-inspired stimulus funds. These funds provided consumers the ability to spend and led to a jump in retail sales from the pandemic-induced inactivity. The graph below from Advisor Perspectives illustrates the pandemic dip, stimulus boost, and the beginnings of a post-stimulus drop in retail sales. Notice the pre-Financial Crisis trend in green versus the lower sloped post-Crisis trend in red. I believe future consumption will return to the red trend line (or below) rather quickly.
One of the most significant factors remains employment. The level of current employees as a percentage of the working-age population remains far below the pre-pandemic amount, and even below the lows experienced during the Great Recession (blue line in graph below). The labor force participation rate (red line below), at 61.6% has not been this low (pre-pandemic) since the mid-1970s. According to the Department of Labor, there are still almost 15 million people receiving some form of unemployment benefit. The lack of further stimulus combined with the extremely high number of unemployed workers (despite what the “official” unemployment rate states) will lead to limited income and spending power.
Also, as highlighted last week, since so much future consumption was pulled-forward through the use of debt-financing, the limited income must be used for debt service in addition to consumption; hence, lower future GDP growth.
As global supply chains return to normal, the supply of goods will again exceed demand putting downward pressure on prices. Economist Dr. Gary Shilling wrote, “Still, much of the rise in commodity prices will probably be absorbed by producers, wholesalers and retailers…Furthermore, goods in total accounted for only a third of consumer spending while services, which use few commodities, equal two-thirds. The strong dollar also offsets rising costs of imports.”
I agree with Dr. Shilling as he states, “Today, there’s tremendous expectation of inflation, as shown by the recent rise in Treasury note and bond yields, but we don’t see the fundamentals substantiating it. If slow economic growth persists this year, as we expect, inflation fears will probably fade and the Treasury note and bond yields will again fall.”
Recently, while many have been calling for the 10-year Treasury note yield to rise over 2%, it has fallen back to 1.47%. There is a strong correlation between economic growth, inflation and Treasury note yields as shown in the first graph above. The stimulus-induced surge in consumption is wearing off, debt is at record levels, and the number of individuals collecting unemployment benefits is substantial. These are not the ingredients for sustained high economic growth.
I believe the surge in growth, inflation jump, and previous rise in the Treasury note yields are all transitory. And remember, a drop in Treasury note yields equals a surge in Treasury note prices.
The S&P 500 Index closed at 4,166 down 1.91% for the week. The yield on the 10-year Treasury Note fell to 1.44%. Oil prices increased to $72 per barrel, and the national average price of gasoline according to AAA fell to $3.07 per gallon.
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