Interest Rates Fall as Inflationary Expectations DeclineAuthor: John MasonLast Updated: January 15, 2015 Interest rates fell again this week and I am still trying to figure out what is going on in the bond market.The yield on the 10-year Treasury note dropped to 1.85 percent at the close of business on Wednesday, January 14, 2015. The last time that this maturity was around 1.85 percent was on May 9, 2013 when the 10-year note closed to yield 1.81 percent.The thing is that at this date in 2013, yields were on the rise. For example, the lowest yield for the 10-year note was achieved on July 25, 2012 when the close was at 1.43 percent.This time around the yield on the Treasury note is coming down. The recent high was achieved on January 2, 2013 when the yield closed at 3.00 percent.In early 2012, the yield on the 10-year was falling. On May 9 2012, the yield dropped through 1.85 percent to close at 1.81 percent.What’s different? Is there anything we can take away from the earlier dive in interest rates to the July 25 low that might help us understand what is going on now? Might the current yield on the 10-year Treasury note drop down to the 1.40 percent to 1.50 percent range?I would like to suggest that we look at two things. First, I suggest that we look at the recent decline in the inflationary expectations investors built into market yields. I develop an estimate of inflationary expectations by calculating the difference between the yields on the 10-year Treasury note and the10-year Treasury Inflation Protected Security (TIPS). This difference is then defined as the estimate investors build into the market through the maturity of the securities.Over the past few weeks there has been a substantial drop in inflationary expectations. Over the past couple of days, inflationary expectations have dropped to around 1.50 percent. Just before Christmas day, 2014, inflationary expectations were estimated to be around 1.70 percent.This is a massive drop in just a few weeks. What has happened? For one, statistical reports coming from Europe indicated that the eurozone experienced a decline in prices from December 2013 through December 2014. Actual inflation in the United States has been very week and declining and along with the European report, market expectations took a nose-dive.Thus, one could argue that 20 basis points in the recent decline in interest rates was due to a decline in investors’ inflationary expectations.One can note that on July 25, 2011 when the yield on the 10-year note was 1.43 percent, inflationary expectations were at 2.10 percent. Inflationary expectations have come down considerably between that earlier date and now. So something else had to be going on in the investment community.The second thing I would suggest looking at is the yield on the 10-year TIPS, sometimes referred to as the “real” yield on Treasury securities. On January 14, 2015, the 10-year TIPS closed to yield 0.33 percent. Note that this yield has fallen from 0.56 percent on December 24, 2014. Thus we have accounted for another 23 basis point drop in the nominal yield on the US Treasury note.So, here is how the decline took place in the yield on the 10-year note from December 24, 2014 to July 14, 2015. The whole decline was 43 basis points from a yield of 2.28 percent to 1.85 percent and was composed of a 23 basis point decline in the “real” yield from the TIPS and a 20 basis point decline in inflationary expectations.But, why is the “real” yield falling? Well, for one thing the “real” yield is associated with the expected rate of growth of the economy. If the economy is expected to grow more slowly, investors will take this into account and reduce the “real” rate of interest built into market yields.It seems that after the first of the year a feeling grew that the US economy would not be growing as rapidly as once believed not to long ago, and this feeling was translated into the financial markets.There is another factor that might be at work here. Sometimes when things do not seem quite right in the world, risk-averse investors seek out a “safe haven”, market where they can put their funds and feel more confident that their money is safe.When this happens, the yield on TIPS may decline in a way that is not associated with a decline in a country’s expected growth rate.A vivid example of this type of behavior was captured a few years ago. The yield on the 10-year TIPS actually went negative on December 12, 2011 and stayed negative for almost a year and one half. The argument given for the TIPS yield becoming negative and staying there for such a long time is that Europe was experiencing a financial collapse. As a consequence, there was a flood of risk-averse money flowing from Europe into the United States seeking a “safe haven.” The money did not start to flow back into Europe until crisis was over. The yield on the 10-year TIPS became positive in June 2013.At the point where the 10-year Treasury note was at its lowest on July 25, 2012, the yield on the 10-year TIPS was a negative 0.67 percent.The question for today concerns just how far the yield on the 10-year TIPS will fall?First, the real rate of interest, the yield on TIPS, has fallen to 0.33 percent. During the time that money flowed in such large quantities to the United States during the European financial crisis, this yield dropped to around a negative 0.70 percent, a full percent below the current level.How far will expectations of slow economic growth or international flows of funds take this yield at this time? I don’t believe that the current international flow of funds will take this yield below zero at this time. Furthermore, I don’t believe that the economic growth expectations will get so low that the yield on the 10-year TIPS will go below 0.10 percent.This would mean that the nominal yield would only decline, for this reason, by 20 more basis points. This, to mean, seems like a large drop, but these are strange times.Second, how low can inflationary expectations go? If anyone would have told me a year ago that inflationary expectations would be around 1.50 percent, I would have told them they were nuts!But, here we are and Europe is facing a period of deflation, Japan can’t seem to shake its deflationary condition, the world economy is slowing down, and there seems to be real concerns about the global stability on the political front.Could inflationary expectations drop another 20 basis points? Wow! Along with a drop caused by international flows, that could put the yield on the US Treasury note around 1.45 percent.Is that possible? Well, the yield on the 10-year German bund is now 0.43 percent. The yield on the 10-yer French bond is 0.66 percent. The yield on similar maturity Spanish bonds is 1.57 percent, the same as the yield on 10-year Canadian government debt. Even Italian 10-year bonds are yielding 1.73 percent.I’d like to think that the probability that US longer-term interest rates would rise over the next year or so is greater than the them falling. But, in this environment, anything seems possible.About John Mason John 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.