Are Bond Interest Rates Finally Beginning to Rise?

interest ratesAre bond interest rates finally beginning to rise?

All winter, investors have been waiting for government bond yields to start moving higher, only to be disappointed again, and again, and again.

There was always some unexpected reason that bond interest rates didn’t rise.

For example, there was the big movement of funds out of the securities of emerging nations.  The reason for this was the effort of the Federal Reserve to begin tapering the amount of government debt it purchased every month.

Last year the Fed was purchasing $85 billion of government debt every month.  Then this amount dropped to $75 billion…then $65 billion…and now the amount is at $55 billion.

The concern was that so much money that had left the United States and ended up purchasing the debt of emerging nations…now, that the Fed was tapering its purchases, these countries would lose funds, which would cause their interest rates to rise…and, so the monies fled back to the United States.

This kept interest rates in the United States lower than they might have been.

Another reason given for the failure of interest rates to rise in January and February was the weather.  Because of the miserable weather during this time period, economic reports came in weaker than expected.  The concern was about the strength of the economic recovery.  Were these weak data just a result of the poor weather conditions or was the economy still on its slower track?

A third reason for the weakness in yields has been the concern over the condition of the Chinese economy.  Several months of “not-so-good” economic reports have left people wondering about how a weak Chinese economy might impact global growth…and make Treasury securities more attractive.

At the end of December 2013, the yield on the 10-year US Treasury bond was around 3.00 percent.

By early February 2014, this yield had dropped to the lower 2.60 percent range.

And, this was a time that interest rates were expected to rise.

In the latter part of March, the yield was still trading in the 2.65 percent to 2.75 percent range.

This week, the 10-year Treasury yield moved up and ended the day yesterday yielding more than 2.80 percent.

The reason that has been given for the recent rise in the interest rate is that it appears as if the economy is really picking up steam.  A hiring report by ADP, a payroll processor, was higher than expected and figures from recent months were revised upwards.  Orders for factories in the United States were reported at their highest level in five months.  The Institute for Supply Management indicated that its manufacturing index rose.  Hope is up for a favorable jobs report this Friday.

Thus, expectations for a stronger economy over the next several quarters have increased.

And, with this rise in expectations, bond yields rose.

As I have indicated before in this blogpost, a bond yield that tends to be related to the future growth possibilities of the economy is the yield on the Treasury Inflation Protected Securities…or TIPS.

By the end of December 2013, the yield on 10-year TIPS had reached a level of almost 0.800 percent.  As expectations risk averse monies left emerging nation investments and as concerns about how strong the economic recovery was, this yield dropped.

In March 2014, the 10-year TIPS was trading to yield around 0.460 percent.

Yesterday, the 10-year TIPS closed yielding about 0.650 percent.  This can be interpreted as a sign that investors are really expecting a stronger rebound in economic growth.

The one consistent in these market movements is that investor’s expectations of future inflation seemed to remain relatively constant, in the 2.2 percent to 2.3 percent range.  Thus, even with all these changes in the international flow of funds and the strength or weakness of the United States economy, the market’s expectations about inflation over the next ten years remained quite stable.

The bottom line of this analysis is that longer-term interest rates are still expected to move higher in the next six months…and to move even higher over the next couple of years.

This is the base forecast.

What the past three to four months teaches us is that a lot of different things can impact yields in the shorter-term.  In terms of overall management of our bond portfolios, we must not lose sight of the longer-term.  We cannot let short-term distractions trick us into emotional trading in response to the latest releases of data.  We must choose a path and then have the patience…and confidence…to weather these diversions.

There will always be a lot of unknown unknowns to enliven the journey.  However, there is one known unknown that will play a role in exactly how this journey is going to evolve and that is the uncertainty that is attached to the future of the Federal Reserve’s monetary policy.

The Federal Reserve has never gone through a situation like the one it is now going through.  So far it has set its course to reduce its excessive amount of monthly bond purchases and has stuck to it.  But, we don’t know what will take place with respect to monetary policy in the future.  And, the banking system has somewhere close to $2.5 trillion in excess reserves held in the vaults of the Fed.  We have no idea what is going to happen to those excess reserves as the economy gathers steam and bank loan demand increases.  We also don’t know how the Fed will respond to banks drawing down these excess reserves to make more loans.

Thus, there is still a large part of the story that has not been completed yet.  All I can say to the playing out of this story is…keep tuned…it is going to be an interesting ride.

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About John Mason

John MasonJohn MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.

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