LearnBonds.com

Making Sense of a Perplexing Year in the Bond Market

Rate this post

world-map-ssTrying to understand the movement in the bond market this year has been perplexing for many.  Perhaps it would be instructive to listen to someone who “got it right” so far in 2014.  If you are interested I would highly recommend reading the interview with Steven Major, global head of fixed-income research at HSBC Holdings, PLC, which appeared in Wednesday’s Wall Street Journal entitled “The Man Who Saw It Coming.”

Mr. Major’s projection for the yield on the 10-year Treasury note coming at the end of 2013 was for the yield to drop to 2.1 percent by the end of 2014.  “He is sticking to that prediction.”

To see a list of high yielding CDs go here.

Tuesday, the 10-year note closed to yield 2.50 percent.  The low close for the year has been 2.33 percent.

On December 31, 2013, the yield on the 10-year Treasury closed a little above 3.00 percent.  Most analysts expected that the rate would go up during 2014, reaching at least 3.25 percent…and with some predicting something in the neighborhood of 3.50 percent.

This seemed to be some good reasons for the expectation that rates would rise.  First, it looked as if the US economy was picking up steam.  After a relatively anemic 2012 and 2013 where the growth rate was in the 2.0 percent to 2.5 percent range, it looked as if real GDP would come in somewhere around 3.00 percent in 2014.

Second, inflationary expectations were poised to rise during the year.  At the end of 2013, investors had built in roughly a 2.25 percent to 2.30 percent expected rate of inflation in the 10-year Treasury yield.  Many analysts believed that as the economy started to grow a little faster that inflationary expectations would begin to rise.

Third, it was believed that European financial markets would continue to recover and as they did the “risk averse” money that had formerly come to the United States seeking a “safe haven” would begin to flow back to Europe.  This would mean that the yield on the Treasury Inflation Protected securities, TIPS, would also rise.

What did Mr. Major see that led him to expect lower interest rates rather than higher ones.  Well, Mr. Major argued, “Globally, if we put together all the central banks, including the Federal Reserve, and sovereign-wealth funds, something like 50 percent of the overall dollar amount of US Treasury bonds outstanding has been taken out of the market.”

And, these purchasers were buying securities for reasons other than yield.  For example, many of these buyers acquired Treasury securities” to manage their foreign reserves.”

In addition, Mr. Major adds, “a shrinking fiscal deficit resulted in a reduction of new Treasury debt sales….The flow of new US Treasury bonds is approximately half today what it was 18 months ago.”

Furthermore, investors did not move money back to Europe…or to Japan…because rates in these countries remained extraordinarily low.  “The 10-year Treasury note’s yield is over four times the Japanese government bond and more than twice the 10-year German government bond.”

Another factor that entered into the equation was the value of the dollar.  “A rising dollar contains inflation because of cheaper prices on imported goods.  If this trend continues, it would put downward pressure on US inflation.  This would be supportive for long-dated US Treasuries, all else being equal.”

And, where is Mr. Major in his forecast for the rest of the year?  Two major items come to the front.  First, inflationary expectations in the United States and in Europe have gone even lower than expected.  In the United States, the bond market is telling us that investors now believe that inflationary expectations are below 2.0 percent.  In Europe, the environment continues to be one of disinflation, and this is causing inflationary expectations to consider the possibility of actual deflation.

Second, there is the uncertainty in the geopolitical world with the conflicts in the Middle East and Russia looking as if there will be major disruptions for some period of time.  In such an environment, investors will continue to keep funds in countries they consider to be “safe havens”.

For 2015, Mr. Major believes that the yield on the 10-year Treasury will continue to trade in the 2.00 percent to 2.50 percent range for much of the year, with rates closing around 2.50 percent toward the end of year.

Mr. Major thinks that the Federal Reserve will finally begin to encourage short-term interest rates to rise in the middle of 2015.  This move in the short-term end of the market will have repercussions in the longer-end of the market.

The area that Mr. Major believes could upset this forecast is in the area of wage inflation.  Wage inflation has been exceedingly low in recent years.  This, he believes, is one of the reasons why there has been very little pressure on prices, which would result in higher prices.  Of course, the weak economy along with structural problems in the economy has kept wage inflation down.

If, wage inflation starts to rise over the next year or two, this will put more pressure on businesses to raise prices.  If investors see this movement starting to take place they will build the situation into inflationary expectations…and this will cause longer-term yields to move further upwards.

I found the reporting of this interview to be quite interesting.  What it does, more than anything else, is to inform us as to the role that foreign happenings are now impacting United States bond markets.  The bond markets are now, truly a part of global financial markets.

We, as investors in bonds, cannot ignore what is going on in the rest of the world and how these global events can impact flows of funds throughout between countries.

This might cause us to be a little cautious of Mr. Major’s forecasts for 2015 because he does not include…at least in the write-up of his interview…any foreign events that might influence interest rates in that year.

In this connected real world, we cannot avoid consideration of these possible foreign events.


About John Mason
 John 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.

All trading carries risk. Views expressed are those of the writers only. Past performance is no guarantee of future results. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.
Avatar

John Mason

Write first comment

Reply

Your email address is not published.