The big drop in US Treasury yields this year has once again confounded the consensus. Benchmark ten-year Treasury yields have declined from 3% to around 2.5% in under five months. Investors that took duration risk were handsomely rewarded, as 30-year long bonds have returned 12.2% year-to-date through May 23, the best performance over this period since 1995. Behind the falling yields is a combination of slowing fundamentals that are supporting continued dovish policy from the Federal Reserve, reduced Treasury supply as the US budget deficit improves, and the influence of global trends.
Examining fundamentals, rising home prices and mortgage rates have taken the momentum out of one of the drivers of the recovery. Median sale prices for new homes were up 12.6% in the first quarter, while the typical 30-year fixed mortgage rate was 4.14%, compared to 3.59% a year ago. With median household real income down about 10% since 2007 it’s not surprising new home sales dropped 14.5% in April. Job gains help, but with household debt still elevated, and purchasing power not making much progress, homebuyers and consumers generally are proving to be more sensitive to interest rates than rate hawks suspected. The latest retail sales figures for April showed almost no growth on the month. No doubt this is the thinking behind the Fed’s continuing dovish statements, dousing market attempts to move the yield curve upward. With no sign of serious inflationary pressures on the horizon, the unemployment rate can likely drop a fair bit more before rates start to rise. Manufacturing growth has also cooled off recently, so the picture could be taking shape yet again of a sputtering recovery. Absent a near-term bounce-back in growth drivers, forecasts will need to be ratcheted down.
The Fed has also had an impact—the cumulative effect of quantitative easing has lowered benchmark yields by an estimated 1.4%, according to the IMF. The mere mention of tapering backed up yields over 100 bps a year ago as the market repriced for QE’s end. This repricing may have been overdone, making the recent fall simply part of the normal iterative price discovery path.
How about demand and supply? There is some evidence of a structural change in institutional behavior in favor of Treasuries. Risk-related regulatory pressure on institutions may encourage some rebalancing out of fully valued equities into high-grade bonds, which some have estimated could generate an extra $300 billion of demand for Treasuries over the next two years. And while investors have obsessed over the Fed-dependent demand side, they may have overlooked the equally rapid improvement on the supply side. Given a falling budget deficit, net issuance of Treasuries year-to-date has amounted to just $127 billion compared to $286 billion for the same period in 2013.
As part of a globalized marketplace, Treasuries are also influenced by overseas trends. With the Eurozone at risk of Japanese-style deflation (its inflation rate of 0.7% is now below that of Japan), the European Central Bank has all but promised an unprecedented move to negative deposit rates at its upcoming June 5 meeting. Core ten-year euro government bond yields have been pushed below 1.5% in the process.
All these factors present an uncomfortable prospect for investors that are short duration. Anecdotal evidence suggests positioning for higher yields and rates may have provided fertile ground for a short-covering squeeze (speculators still held over 80,000 net short positions in the ten-year Treasury future in mid-May).
Based on the forward curve, market expectations are for the Fed funds rate to go no higher than 2% by April 2017, in sharp contrast to many pundits’ earlier forecasts of the rate normalizing around 4%. As for ten-year Treasuries, what is now discounted is a 2.86% yield in one year’s time, rising to only 3.32% by April 2017. If that’s the case, the carry on longer bonds probably makes shorting a losing trade. And the fundamental implication is that the recovery will remain weak and fragile for years to come, with a combination of tepid growth and low inflation.
However, we should caution that historically the market’s expectations, as expressed in the forward curve, have often proved to be wrong. With a Fed that is determined to rekindle strong growth and the recent plunge in yields, the question is whether the market is a leading indicator of slowing growth and inflation or simply reflects a market wrong-footed by short-term news flow that forced the bond bears to cover.
Stephen Saint-Leger is a Managing Director on the Cambridge Associates Global Investment Research team.