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While many expect a pick-up in US economic activity in the second half, Treasury rates remain low – a conundrum that frustrates bearish bond investors who believe 2014 is the year of much higher yields.
Just under a decade ago, when Alan Greenspan was Federal Reserve chairman, he described the then low level of a 10-year Treasury yielding 4.15 per cent against the backdrop of tightening monetary policy as a conundrum.
Today, many in the bond market are once more shaking their heads when they see the 10-year note yielding 2.68 per cent, down from 3 per cent at the start of January. Given that bond prices move inversely to yields, sections of the US Treasury market have performed strongly since the year began.
Long-term Treasury bonds or those with a maturity beyond 25 years have delivered a total return of 10 per cent in 2014, according to Barclays Indices.
The pressing question is why are long-dated government bonds doing so well and handily eclipsing this year’s returns for lower rated company paper and equities? Moreover, what does this mean for the economy and to investors betting on stronger growth and better returns from riskier assets in the coming months?
Unlike 2005, when Mr Greenspan talked of a bond conundrum, the Fed is not raising its key borrowing rate.
However, the recent decline in long-term Treasury yields has occurred while the central bank has stepped back from buying long-term Treasuries via its taper of quantitative easing. A further cut of $10bn in the Fed’s monthly bond purchases to $45bn is expected at next week’s policy meeting.
David Ader, at CRT Capital, says we are seeing markets adjust to less easy money from the Fed.
“To the extent QE benefited risk assets, the unwind of QE removes that as a prop.”
The interplay between equities and long-dated Treasury bonds has also been driven by pension funds and insurers cashing in on last year’s 30 per cent rally in the S&P 500 and switching back into government bonds that back in January had experienced a hefty rise during the preceding seven months.
It appears clear that the bond market has priced in the removal of QE, given last summer’s rise in yields, and attention is now focused on when the Fed will finally start tightening policy.
While long-term yields have fallen, those for shorter dated maturities, which are more sensitive to monetary policy expectations, have risen since January. This has resulted in the shape of the yield curve – or the relationship between short- and long-term yields – flattening in the vernacular of the market. It’s the kind of behaviour we see ahead of central banks shifting policy.
“The yield curve quite naturally starts flattening well in advance of a hiking cycle and, indeed, by the start of the hiking cycle, much of the flattening has taken place,” says Mr Ader.
It appears likely that, while a stronger economy stands to push bond yields higher, such a move will be led by shorter maturity Treasuries and not the long end.
Moribund inflation also supports the case for holding long-dated bonds and one message from the Treasury market stands at odds with the consensus call of a sharp rebound in the economy over the coming months. Low bond yields and inflation suggests an economy still deleveraging after the bursting of the housing and credit bubble.
According to recent analysis by Laffer Associates, the low level of long-term US bond yields is a function of the economy’s hangover in the aftermath of the housing price bubble bursting.
“The structural forces resulting in low long-term bond yields are very strong and it could be another three years before the Fed’s current policy pushes up inflation expectations and ultimately inflation itself,” says Kenneth Peterson at Laffer Associates.
So while many traders and investors shun long-term bonds and have duly missed the solid performance since January, their bearish stance may not be vindicated any time soon.
When it comes to consensus about bond yields, the US Treasury market has long frustrated the wisdom of market mavens. Just ask Doctor Greenspan.
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