Why Do Bond Yields Continue to Fall?
by Rick Welch on Dec 3, 2014
Sometimes looking to the past can be informative and offer some clues as to where we may be in the future. Other times, the past just makes predicting the future more difficult. This sentiment would seem to describe perfectly the task of projecting bond yields during 2014. On December 3, 2013, the yield on the benchmark 10-year US Treasury stood at 2.78%. Just a few weeks later we began 2014 with the benchmark yield at 3.03%, a starting point that most analysts felt would lead to higher yields of 3.5% or more by 2015. What happened? We see current yields of 2.30%, which is an improvement from the 2014 low level of 1.87% seen on October 15th. Normally, with an improving domestic economy we would expect to see bond yields gradually rising. If the recent recession has taught investors one lesson it is that these times are anything but normal.
While the economy at home has largely repaired itself, much of the developed global economy is in a weaker condition. Heightened concerns about slowing (or absent) growth in Europe, China, Brazil and Japan and low global inflation all play a role. The factors that led many strategists to forecast higher yields - such as faster economic growth in the US and the end of QE - have been overwhelmed by the weakness overseas. Falling yields on Eurozone bonds have acted to cap Treasury yields amid expectations the ECB will move to further stimulate Europe's economy by expanding debt purchases to include government bonds. The Bank of Japan in October increased asset purchases, a move that sent investors in search of higher yields in safe havens, like Treasury bonds. Demand for US Treasuries has increased as other sovereign bond yields have fallen to new low levels as seen in these examples of current 10-year government bond yields: Germany (0.74%), Italy (2.01%) and Japan (0.42%).
Energy prices are a significant component of forward looking inflation expectations. As crude prices move lower, so do inflation projections which allows investors to be satisfied with lower yields. In addition, the US dollar has strengthened against many major and emerging market currencies in 2014, making US bonds look more attractive. The push behind the dollar rally is the belief that the Federal Reserve is likely to lift short-term interest rates next year while other major central banks remain in easing mode. We should learn more about the Fed's 2015 plans at the next scheduled Federal Open Market Committee meeting on December 16-17. Recent Fed guidance has suggested that any tightening will be data dependent, rather than date dependent. Managing interest-rate expectations will be a difficult task for the Fed, which risks derailing economic growth if its actions prompt borrowing costs to rise faster than officials believe is warranted by economic conditions. Recently, the Fed has used the term "considerable time" to communicate its intentions on how much longer it will hold short-term rates near zero. Most analysts now predict the summer of 2015 for the first sign of monetary tightening. New York Federal Reserve President Bill Dudley recently offered this calming guidance, "When we do begin to tighten monetary policy, the pace of tightening will depend not only on the outlook but also how financial market conditions respond as we begin to remove monetary policy accommodation."
