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Making Sense of the Movement in Longer-term Interest Rates

magWhat is going on in the bond market? The yields on US Treasury bonds continue to remain at levels below what most investors thought they would see here in 2014. The yield on the 10-year Treasury bond closed at 2.45 percent on Tuesday.

This is not as low as the level reached in 2012 when the yield dropped below 1.50 percent, but it is way below what most observers, including myself, thought that they would see going into the last half of 2014.

At the end of last year, I personally believed that the yield on the 10-year would be up in the 3.00 percent to 3.50 percent range…with the market tending more toward the higher value.

So, in terms of the yield, what has happened since the end of last year?

Well, on December 31, 2013, the yield on the 10-year was 3.04 percent.  The yield on the 10-year Treasury Inflation-Protected Security was 0.78 percent.  The difference between these two yields is defined as a proxy for investors’ inflationary expectations. In this case, the expected inflation built into the market yields was 2.26 percent.

Where are we presently?

At the close of business on Tuesday, August 12, the yield on the 10-year was 2.45 percent.   The yield on the 10-year TIPS was 0,20 percent.  Hence, the market’s estimate for inflationary expectations was 2.25 percent.

The difference between the two is that the yield on TIPS was 50 basis points lower in August than it was at the end of last year.

As I have written before, the yield on TIPS is often taken to serve as a proxy for the expected real rate of interest of the economy, which is also related to the expected real rate of growth of the economy.

Using this line of thinking, one could therefore argue that investors are currently expecting that the United States economy is going to be growing more slowly in 2014 than they expected it to grow at the end of last year.  And, given the performance of the economy in the first half of 2014, many analysts did lower their predictions about how much economic growth will be achieved this year.

But, at the present time, even the lowest forecasts for 2014 and beyond are for annual rates of growth of 2.0 percent to 2.5 percent, and some analysts, myself included, have hung on to their belief that the growth rate will be closer to 3.0 percent.

This is not a great rate of growth, but the question we face is whether or not an expectation of economic growth in the 2.5 percent range warrants an expected real rate of interest of 0.20 percent?

I would argue that it doesn’t.  Therefore, we need to look elsewhere to try and understand why the yield on the 10-year TIPS is running at such a low rate.

Moving on to the next possible cause of the low interest rates one is drawn to the issue of risk.

I have written several posts for LearnBonds where I have argued that a low yield on the 10-year TIPS can be the reflection of an investor flight to a safe haven.  My argument was that the financial disruption in Europe during the 2011 through 2013 period resulted in “risk averse” money leaving Europe is such large amounts that the yield on the 10-year TIPS actually dropped precipitously and even became negative.  On August 10, 20111 the yield on the 10-year TIPS actually went negative for the first time.  On June 6, 2013, the yield was negative for the last time in this experience.

It is my belief that we have experienced another flight to safety this spring and summer as monies have left Europe due to the uncertainty in the world created by the situation in the Middle East and by the events in the Ukraine that have resulted in sanctions and other manipulations of economic relationships.

In late April, for example, the yield on the 10-year TIPS was 0.50 percent, not as high as it was on December 31, 2013, but still 30 basis points above where it is now.  One could argue that the drop-off in yield in the February/March period was due to the bad weather and the growing concern that economic growth in 2014 would not be as robust as had been previously expected.

As it became apparent in April and May that the economy was bouncing back and that expectations of real growth were improving, investors were hit with the events in the Ukraine and the conflict in Gaza between Hamas and Israel.

While expectations about future growth were being raised, the market was hit by the large flows of funds seeking a safe haven from military and political conflicts taking place around the world.

I believe that this argument is supported by the fact that the yield on German bunds, another “safe haven” investment, dropped to historic lows during this time period.  On December 31, 2013, the yield on the 10-year German bund was 1.94 percent…almost 2.00 percent.

This past week, the yield on the 10-year German bund has closed at its historic low of 1.05 percent…almost fifty percent lower than where it traded at the end of last year.

There are a lot of things going on in the world these days.  For investment purposes it is vital to try and understand how these “happenings” are impacting the assets we invest in.  The above analysis is my attempt to make sense of the movement in longer-term interest rates this year so that I can have more confidence in my understanding of what is going on and how investors are responding.

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.


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