Summary:
- Larry Summers says he has expected the current rise in 10-year bond yields, and expects further increases.
- Expected “further adjustment” in markets as a result of higher rates, implying downside risks to equity and fixed income markets.
- His outlook is based on an expectation of inflation remaining higher than the fed’s 2% target, a higher real interest rate, and a return to higher term premiums.
Full Synopsis
Speaking on Bloomberg Wall Street Week, Larry Summers, the former Treasury Secretary and President of Harvard, said that he had expected the increases in the 10-year yields and expects further increases ahead. Higher interest rates cause bond prices to fall, and can also negatively impact equity prices if the discount rate at which equities are valued falls.
Summers explained that the 10-year rate is a function of 3 components: expected inflation, real interest rates and term premium. Summers expected inflation to average above the Federal Reserve’s 2% inflation target over the next 10 years as a result of trends such as shortages of workers, labor empowerment, and reduced globalization leading to an inflation rate closer to 2.5%. If real interest rates return to 1.5% and term premium (historically 0.75% – 1.5%) return to 0.75%, the 10-year yield could be expected to run at a minimum of 2.5% + 1.5% + 0.75% = 4.75% vs the current 10-year yield of 4.28% as of the close on August 17th.
Larry also mentioned upside risks to the US federal deficit, mentioning that although the CBO projects a deficit of 7.5% over the next 10 years, the actual deficit is likely to be much higher especially with yields higher than the 2.75% the CBO projects. Larry mentioned that financial markets may need to make “further adjustments” to higher 10-year rates, implying lower prices for stocks and bonds.
