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Making Sense: Four Reasons Low Bond Yields Are Here To Stay

At the time of this writing, the yield of the 10-year UST note stood at 2.13%, the yield of the 30-year U.S. government bond stood at 2.685% and the 10-year TIPS breakeven stood at 171 basis points, indicating a market outlook of 1.71% for headline annual CPI, over the next ten years. The bond market does not see much inflation. Although pundits are having difficulty explaining this to their readers and viewers, the explanation is quite simple. It comes down to what I call the “Four Pillars of Low Inflation”:

1)    Technology

Technology is inherently disinflationary. From consumer electronics, to appliances, to automobiles; capabilities of goods (and services) have tended to increase at a faster pace than or, in some instances, in the absence of price increases. Thus, technology augurs for low inflation.

Tesla Elon Musk
Photo: Wikipedia/Creative Commons

2)    Demographics

As a population ages, it tends to spend less on discretionary items, less on home purchases and less on children’s items. Older consumers tend to save more and direct more of their, often limited, income on necessities, such as healthcare. Older consumers are less likely to see their household incomes rise as much as working-age consumers. Thus, purchasing power in an economy can grow more slowly in an aging/older economy versus a more youthful economy. An older population can augur for lower inflation rates.

3)    A New Oil Production/Consumption Paradigm

For the past 50 years, rising oil prices have been a major driver of inflation pressure. However, with the rise of (increasingly-efficient) domestic oil production, we are awash in oil. At the same time, in spite of rising foreign middle-classes, demand growth has been slower than many economists assumed. This is due, in large part, to greater energy consumption efficiencies and changes in consumer lifestyles, which result in lower per-capita energy consumption.

4)    Monetary Policy Renormalization

It is Monetary Policy 101 that reducing monetary policy accommodation is anti-inflationary. One can argue that Fed policy remains accommodative, but one can also argue that monetary policy is less accommodative that in was a year ago. Thus, a flatter yield curve is a logical response to the Fed lowering the level of punch in the bowl. 

Making sense

In my opinion, when one takes a complete view of economic and monetary policy conditions, one cannot help but to conclude that we are in a structurally slow growth and low inflation environment. Fiscal policies could boost economic growth and/or inflation, but if inflation pressures surge, the Fed is likely to tighten monetary policy at a quicker pace.

The Fed has a mandate, given to it by Congress, to maintain price stability, along with a secondary mandate to maintain full employment. The Fed has no obligation to support political agendas or manage market volatility.

In my view, we are likely to see 2.00%-area GDP, for the balance of the current expansion cycle, with the occasional quarterly GDP print around 3.0% and the occasional GDP print around 1.0%. It appears that it is for this scenario that the UST market is pricing. If you have been following Bond Squad, you knew that already.

It has been popular to assume that, when the Fed does reduce the size of its balance sheet, long-term UST yields would surge higher. I have pointed out, on numerous occasions, that since the Fed’s holdings are weighted on the mid-portion of the yield curve, it could be the five-year UST yield which rises more than 10-year or 30-year UST yields. This has happened, particularly after the Fed announced its plans to shrink its balance sheet. Those looking for surging long-term rates because of a reduction of Fed reinvestment are likely to be disappointed.

Those of you looking for a pickup inflation might get your wish, in July, at least to some extent. From 6/29/16 to 8/2/16, the price of WTI crude oil fell about 10 points to $39.51 a barrel. Thus, if oil prices can hold in the low $40s, we could see headline inflation measures pick-up, albeit modestly, over the next month.  However, after that, annual oil price comps could be negative, thereby suppressing headline annual inflation readings.

 

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About Thomas Byrne
Thomas Byrne has achieved a 26-year career in financial services, 23 of which have been spent in the fixed income market sector. In his role as Director of Fixed Income for Wealth Strategies & Management LLC., Byrne is responsible for providing strategic analysis and portfolio management to private clients and institutions, in addition to offering strategic advisory services to other financial services organizations. Byrne's areas of expertise include trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt, and convertible bonds. Additionally, Byrne provides analysis, strategy, and commentary within the fixed income market. Prior to joining WS&M, Byrne worked as Director in the Taxable Fixed Income Department of Citigroup, Inc., in addition to predecessor companies in New York, NY.
Twitter: @Bond_Squad
E-mail: Thomas.byrne@wsandm.com

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Thomas Byrne

Thomas Byrne serves ad the Director of Fixed Income for Wealth Strategies Management LLC. Thomas 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. 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.
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