By Fritz Meyer, Independent Economist and Market Commentator
With interest rates at record lows, many economists predict a rosier picture for yield-searching investors by year-end 2018. Will this prediction hold true? This market commentary explains.
Our generation of investors has witnessed an all-time aberration in long-term interest rates since the U.S. constitution was ratified in 1789. Figure 1 illustrates the inflation and interest rate spiral of the 1960s and 1970s, which culminated with a peak long-term bond yield of 14.59 percent in 1982. For the 34 years since 1982, bond yields have been trending steadily lower.
In 2011, when the U.S. 10-year Treasury bond yield plunged from 3.75 percent to 1.7 percent, most experts said enough is enough — 1.7 percent doesn’t make sense, yields can’t go any lower and predicted yields would start marching right back up to 3.75 percent within a couple of years.1 Flash-forward to 2016, with yields at 1.56 percent, lower than anyone thought possible. So, what’s behind today’s epic-low bond yields, and where do we go from here? This article explores answers to these two questions.
Before we delve into these two questions, it’s useful to note how the record-low U.S. Treasury bond yields illustrated in Figure 1 have taken bond yields all across the quality spectrum to record lows. Treasury bond yields set the level for corporate and mortgage bond yields, which trade at varying spreads to Treasury bonds.
Figure 1: History of Long-Term Interest Rates
SOURCE: Online Data Robert Shiller, data through August 2016.
U.S. Treasury bond yields have historically been a function of two key variables: 1) inflation expectations and 2) the expected supply of new U.S. Treasury bonds that is, in turn, a function of the level of federal deficit spending. The downward trend in both of these partly explains today’s low bond yields.
Inflation (refer to Figure 2) has been trending steadily lower, but has recently recovered from its 2015 oil-price-collapse slump. Consequently, most economists, as well as the Federal Reserve (Fed), expect inflation to pick up in the period ahead. Core inflation (i.e., inflation minus food and energy) has risen to +1.4 percent year-over-year, a level that was last seen in 2012.
Figure 2: Inflation Measured by Personal Consumption Expenditures (PCE) Price Index
SOURCE: U.S. Commerce Department and U.S. Bureau of Economic Analysis, data through July 2016.
In addition, federal spending deficits (not shown) have improved from their recession depths and are projected to remain fairly benign for the several years immediately ahead. However, the government ’s deficit-spending problem has not gone away, and the Congressional Budget Office’s latest long-term, debt-to-gross domestic product (GDP) projections (also not shown) are scary indeed.
Hence, notwithstanding recent positive trends in inflation and deficit spending, today’s 10-year U.S. Treasury bond yield at 1.56 percent is so low that it simply doesn’t make sense given that both inflation and federal deficits are expected to trend higher in the years ahead. What’s really different today, and what defies logic, is that the yield on a 10-year Treasury Inflation-Protected Security (TIPS) is zero.
A TIPS bond is one that reimburses the investor for actual measured inflation during the bond’s term. The blue line in Figure 3 represents the term premium investors have historically demanded in return for tying up their money in a 10-year loan to Uncle Sam. Note how the term premium, previous to the Fed’s quantitative easing (QE) program, was 2 percent or greater for most of U.S. financial history. Yet, the term premium has disappeared. What explains this development? The answer: QE bond-buying efforts.
Figure 3: U.S. Treasury Bond Yields (10-Year Maturity)
SOURCE: U.S. Federal Reserve, data through August 2016.
While the Fed wound down its QE efforts in October 2014, U.S. Treasury bond yields have continued to trend down due to the European Central Bank’s (ECB’s) QE program. Note the near-perfect correlation of U.S. Treasury bond yields to the German bund yield in Figure 4. Because bond market investors are not constrained by national borders, the ECB’s aggressive QE implementation has taken U.S. bond yields lower with German bund yields, even though the ECB can only purchase European debt instruments.
Figure 4: U.S. Treasury 10-Year Bond Yield vs. German 10-Year Bund Yield
SOURCE: The Wall Street Journal, data through Sept. 7, 2016.
What’s in store for U.S. bond yields from here? The Wall Street Journal’s September 2016 poll of 70 economists has a mean forecast of a 2.7 percent yield on the 10-year U.S. Treasury bond by year-end 2018, up from 1.56 percent today. However, as long as Mario Draghi, the ECB chairman, continues his QE efforts, it’s likely that U.S. bond yields will be driven, artificially, by ECB policy rather than by Fed policy. In fact, Draghi has most recently doubled down QE efforts by purchasing European corporate bonds as the supply of European sovereign bonds runs thin.
All of these factors suggest that the search for yield could intensify as U.S. investors gradually become convinced of the unlikelihood that bond yields will turn higher any time soon. This is precisely contrary to what most economists have been predicting and continue to predict. Under this scenario, corporate bond spreads to Treasuries could compress. Additionally, yields on higher risk investment options could attract even more attention.
If it is actually the ECB that is setting U.S. Treasury bond yields, what does this imply for Fed policy as to short-term interest rates? In her speech on Aug. 26, 2016, Fed Chair Janet Yellen made a positive assessment about the U.S. economy. As Yellen stated, the Federal Open Market Committee (FOMC) “… continues to anticipate that gradual increases in the federal funds rate will be appropriate over time to achieve and sustain employment and inflation near our statutory objectives.” In actuality, the Fed’s desire to get the interest rate normalization process underway might b easier said than done.
Figure 5: Yield Curve (The Differential Between Short-Term Interest Rates and Long-Term Bond Yields)
SOURCE: National Bureau of Economic Reserve and the U.S. Federal Reserve, data through August 2016.
Going forward, the yield curve in Figure 5 is the one to watch. The closer the Fed gets to flattening or inverting the yield curve by hiking the fed funds rate, while the ECB is holding down long-term bond yields, the higher the likelihood of recession and a bear market in stocks. With inflation still well below the Federal Reserve’s 2 percent target and the unemployment rate still higher than what is considered full employment, such a scenario is the last thing the Fed wants to engineer at this juncture.
1 The Wall Street Journal’s monthly survey of 70 economists, November 2011.
About the Author
Fritz Meyer publishes periodic updates and opinion on the economy, markets and investment strategy. A market commentator and economist, he has been a frequent guest on CNBC, Bloomberg TV and Fox Business Network, and has often been quoted in financial and business publications. Prior to starting his firm in 2011, Mr. Meyer spent 15 years with Invesco, where he was the firm's senior market strategist, and began his investment career in 1976. Mr. Meyer earned a Bachelor of Arts from Dartmouth College with a distinction in economics and a Master of Business Administration from the Amos Tuck School, also at Dartmouth College.
Mr. Fritz Meyer is a compensated writer who was commissioned by CNL Securities for this market trends update. The opinions expressed by Mr. Meyer are not necessarily wholly reflective of the views of CNL Securities. His statistical data are his own and are believed to be accurate. All graphs were created by Mr. Meyer. This information is provided only as a summary of complicated topics and does not constitute legal, tax, investment or other professional advice on any subject matter. Further, the information is not all-inclusive and should not be relied upon as such. You should not use this information as a substitute for your own judgment, and you should consult professional advisors before making any investment decisions.
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