Why Did Long-term Rates Fall Last Week?

 
falling ratesThis time last week, the buzz in the fixed income markets was about the spike in rates which followed last week’s FOMC meeting. Less dovish comments, both in the FOMC statement and from Fed Chair Yellen during her press conference, pushed yields higher throughout most of the yield curve. However, a funny thing happened on the way to higher rates.
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Following last week’s Fed comments, it appeared as though the bond market was all set to push rates higher so why did long-term rates fall?  Fed Chair Yellen stated that Fed Funds Rate hikes could begin as little as six months following the conclusion of Fed asset purchases. This would put the First Fed Funds Rate hike in the spring or summer of 2015. The market responded to this less dovish language by pushing rates higher across the yield curve. Immediately, bullish and hawkish market participants and pundits began rationalizing the Fed’s apparently less dovish tact. They pointed to the Fed’s economic forecasts, corporate profits and to the belief that emerging markets would heal (with China simply re-inflating its bubble with more stimulus). Pundits drew attention to Europe, which is showing some signs of growth acceleration. However, it is a week later and rates on the short and intermediate areas of the curve have stopped rising. Long-term rates have fell to levels which are lower than they were immediately preceding the March FOMC meeting. In fact, the yield of the 30-year government bond fell to its lowest level since last July. If the Fed could tighten sooner than expected and the outlook for the economy is a bit more optimistic, why did long-term rates fall significantly during the past week?
We believe the answer is: Light inflation pressures. As we wrote in last Thursday’s “Making Sense” report, long-term rates are proxies for interest rate expectations. At the present time, there are several sources of disinflation and (potentially) deflation emanating from around the globe. In spite of what is being said on financial television, Russia is not the main driver of falling long-term rates. We believe the main drivers of low long-term rates are:
•Low wage growth:  There are few reasons to raise wages above the rate of inflation. If household income (wages, investment income, etc.) does not outpace inflation by a fair margin, it is unlikely that there will be internally-driven price pressures. Increased household
leverage could increase demand and push prices (and therefore, long-term) rates higher, but without the potential for wage increases, many consumers are reluctant to take on more household debt (if they can get approved in the first place).
•Slackening demand for commodities: Slowing emerging economies has reduced the demand for commodities. From copper, to rubber to crude oil, demand has fallen in economies which were supposed to drive demand for decades to come. Increased energy supply (from more stable parts of the world than in the past) has also helped to keep inflation low.
•Deflation and disinflation in foreign economies:  Renewed signs of disinflation are cropping up in Japan, prices have declined in China and Europe is teetering on the precipice of deflation (inflation in Spain printed at-0.2% last week). Headline Eurozone inflation is expected to print at 0.6% next week. Deflation and disinflation in the world’s largest economic bloc has to result in moderating global inflation pressures. The U.S. economy is not experiencing much internal inflation pressure as annualized PCE printed at 0.9% (1.1% core).  Inflation running at 0.9% is downright frightening for central banks.
•Global interest rates:  German 10-year yielding about 1.50% (like the U.S. 30-year, trading at the lowest yield since July 2013) and the Spanish 10-year note yielding 3.24%, what yield should investors accept for lending the U.S. government money for ten years? We would put up a forceful argument that the U.S. 10-year note yield should not exceed that of Spain’s 10 -year. Last week’s auction of two-year, five-year and seven-year Treasury notes (the latter two experiencing the strongest demand in months) indicate even moderate rat e increases in theU.S. attract investor capital in today’s environment.
•Tighter Fed Policy:  Fed tightening tends to result in a flatter yield curve. Typically the curve begins flattening after period of time after the Fed begins raising the Fed Funds Rate as it usually takes a few months before the anti-growth/anti-inflation effects of higher short-term rates are felt in the real economy. However, U.S. growth is only moderate at the present time, a time in which Fed policy is extremely accommodative. To Fed policy into its proper perspective; the Fed Funds Rate fell to 1.00% in June 2003 (the lowest since 0.68% in July 1958) and remained at 1.00% for a year (the longest the Fed Funds target rate remained at 1.00% or lower in Fed history). Compare this to a Fed Funds Rate which has been set in a range of 0.00% to 0.25% since December 2008, two rounds of “traditional” QE, a Fed extension swap (twist) in which it sold short-term debt and purchased long-term debt and more than a year of outright long-term asset purchases (which continue, albeit at a continually slower pace). If the Fed halted assets purchased altogether and raised the Fed Funds Rate to 1.00%, policy would still be extremely accommodative on a historical basis. However, that would probably slow the economy, flatten the curve and push long-term yields lower.
We advise readers to pay close to the flattening yield curve. A flattening yield curve is usually indicative of disinflation and an economy which might be slowing (or at least leveling off).

By Thomas Byrne – Director of Fixed Income – Investment Consultant

thomas bryneThomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.

Employment

  • November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
  • December 2011 – November 2012 – Bond Squad, Kunkletown, PA
  • April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
  • June 1986 – March 1988 – E.F. Hutton, New York, NY

Thomas Byrne

Director of Fixed Income
Wealth Strategies & Management LLC
570-424-1555 Office
570-234-6350 Cell
Twitter: @Bond_Squad
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.“Bond Squad is my favorite bond investing newsletter. It combines common sense with deep market knowledge.”
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