Capital Markets Update #31

What do we know about the US Economy and a 5.00% 10-year Treasury rate? 

Well, as best as we can figure, its complicated.  The truth is that interpreting historical economic performance in reference to a single constant (in this case, the 10-year Treasury rate) is a nearly fruitless enterprise.  The reason being that the US economy is extraordinarily dynamic, with ever-changing elasticity to various inputs over time.  Trying to compare the US economy of the 1990’s to today is tantamount to comparing market dynamics in the S&P 500 before the proliferation of the personal computer to today’s highly-automated and uber-technical market mechanics.  So, when pundits reference a 5.00% 10-year treasury rate as an almost hegemonic doombringer, plug your ears and don’t read the press.  However, we do believe some relationships are relatively reliable.  For instance, higher risk-free rates raise the overall cost of capital, and, usually, the cost of equity as well.  Present values suffer in this environment without a corresponding increase in future growth expectations.   Similarly, higher short term and long term rates feed directly into current and future borrowing costs for levered companies.  In a highly levered environment, any perceptible move in borrowing costs materially impacts coverage, free cash flow and ultimately values.  But this scenario is not necessarily in play today; companies both small and large are generally sustainably levered.  We are most interested in what the change in borrowing rates does in practice, notably forcing stakeholders to make more discerning capital spending decisions.  These are the factors we want to evaluate in this piece.  How do we index today’s growth outlook against the growth outlook during prior periods of high interest rates?  And what can we learn about the change in spending decisions from stakeholders, including governments, companies and consumers, during historical periods of “high rates” and how could that apply in today’s economic environment?

We pulled some interesting historical growth and inflation data.  According to FRED data dating back to 1990, we’ve had six legitimate periods where Real GDP growth (excluding inflation) exceeded 2.5% annualized for a minimum of four consecutive quarters.  There are a bunch of additional intermittent readings in excess of 2.5% growth, but we’re looking for a sustained period of growth.  During these qualifying periods (a total of 68 quarters) the average monthly Core CPI reading was 2.7%.  Thus, we saw strong GDP growth (> 2.5%), after adjusting for inflation, while experiencing higher-than-Fed-target inflation.  If you adjust for periods where real GDP growth annualized exceeded 3.0% for four consecutive quarters, core inflation amongst this dataset averaged 2.6% across a total of 40 separate datapoints.   Clearly higher growth did not come at the expense of higher core CPI.  Interesting.  We will focus on periods where real GDP growth exceeded 2.5% for a minimum of four consecutive quarters.  During the first nearly continuous qualifying period from 1992 – 2000, the average 10-year yield was about 3.0% above GDP growth from 1992 – 1995 and about 1.5% above growth from 1996 – 2000.  For reference, the late 1990’s experienced a jump in GDP growth with the proliferation of modern technology as rates dropped by about a point.  So the economy benefitted both ways.  During the next continuous period of exemplary GDP growth from 2003 – 2006, the 10-year was about 0.70% above growth.  For reference, the average 10-year yield during this period was 4.30%.  Thereafter, this whole relationship inverts. During the qualifying periods in both 2014 and 2017, the 10-year gap to underlying GDP growth was about -0.60%.  The 2021 datapoint is irrelevant and post-Covid in 2023, the gap started to reflate back to 1.0%. 

The point we’re making here is that the economy has experienced relatively successful real GDP growth under a range of both 10-year Treasury and inflation scenarios.  Critically, our last real GDP growth estimate in Q2 2026 came in at 1.5% against the then 10-year yield of 4.4% (a gap of ~3.0%).  However, if we were to adjust out the material drag AI capex imports had on overall GDP performance, the data would impute a relatively sustainable 2.0% gap in GDP growth to 10-year yields.  If we were to isolate growth in private personal and corporate spending, which collectively make up about 85% of all US GDP, the gap narrows further to 1.5%.  We believe this data helps contextualize the relevance of a 5.00% 10-year Treasury in that today’s economic growth profile may very well justify the present yields.  We have a decent amount of data to support the fact that the US Economy hums when the delta between the 10-year Treasury yield and GDP growth sits around 1.0%.  Apparently, as proven in the 90’s, we can get away with a delta up to about 3.0% provided other stimulants are on the table.  For instance, in the early 1990’s rates were falling, not rising as they are today.  Such a positive expectations incentive is powerful.  However, depending on which GDP metric you use, we’re probably somewhere in the 1.0% - 2.0% gap range today, which history tells us is not destructive to the go-forward economic outlook, at a minimum.   If we were to experience a discernable slowdown in real economic growth without a corresponding drop in 10-year yield, one could argue we would have a pretty serious problem on our hands.  We will continue to watch this relationship over the coming year to see how it all works out.  

Our second pertinent theme touches on the view that higher base rates inhibit net new investment. New investment today drives future growth; therefore, higher base rates have a probability greater than you’d like to admit of limiting future growth….in theory.  We ran a FRED schedule of Total Capital Expenditures divided by annual nominal GDP.  Interestingly, this figure peaked at about 32% in both 2000 and again in 2005.  We reached a post-GFC, pre-Covid high of around 28% in 2018 and are just now getting back to that level.  Without being overly prescriptive about it, the data clearly shows the only period since 1990 where CapEx as a percent of GDP has moderated or declined (recessions notwithstanding) occurred from 2022 – 2025.  Not ironically, this coincides with the 10-year Treasury yield increasing from 0.65% to 4.50%.  For reference, the 10-year Treasury dropped steadily from highs around 8.00% in 1990 to its low of about 0.65% in 2020.  We will note that from 1990 – 2000, the 10-year Treasury averaged about 6.00% and CapEx as a percent of GDP reached a high of 32%.  Rates were dropping not rising and real GDP growth averaged 3.9% for the decade.  From 2000 – 2007, 10-year rates averaged 4.50% and Capex as a percent of GDP again nearly touched 32%.  Rates were gradually declining not rising, but again, GDP growth averaged 3.6% for the four-year period leading up to the CapEx spend peak.  The takeaway being, the nominal base rate is not the deterministic variable in GDP growth, nor is it necessarily the deterministic variable in overall CapEx spend.  The US economy has been successful in many 10-year yield scenarios at, above or around 5.00%.  The data creates a compelling case that investors (both personal and corporate) are most willing to spend in decreasing rate environments when GDP growth exceeds 2.5% sustainably.  You may say “well that’s obvious genius,” but its noteworthy to point this out as it helps us contextualize our current environment.  In today’s case, its unproven whether GDP growth exhibit sustained strong performance and rates don’t appear to be falling any time soon.

We guess this work has allowed us to focus on underlying growth as a critical input to analyzing economic durability in the face of “higher” risk free rates.  For instance, if real GDP growth is ~3.0% we can likely accept 5.00%+ Treasuries.  If the Treasury yield runs to 5.50% and growth pulls back to 2.50%, we should pay attention.  Beyond that, it could be concerning. We should also watch to confirm CapEx spend as a percent of GDP does not slide dramatically below 28% and retrench around levels we saw back in 2010 - 2015.   Don’t look now, but the AtlantaFed Real GDP Now forecast calls for a 5.00% GDP growth rate in Q3 2026, with a statistical mean forecast error of about 0.70% with 15 days to go prior to the GDP release.   Basically, they think they’re generally on top of the right number this close to the upcoming GDP release. 

One thing of which we are sure is that we will continue to keep tabs on these interesting statistical relationships in the months to come.