What is Going on in the Bond Market?

question mark dollarWhat is going on in the bond market?

The yield on the 10-year Treasury Inflation Protected Securities (TIPS) closed below 20 basis points on Wednesday, May 28.

This yield has not been so low since the middle of May in 2013.  The yield had actually been lower, but the rate had been so low because of all the money that had gravitated to the United States because of the financial conditions in Europe.

Over the past year, this yield had risen into the range of 80 basis points to 90 basis points.  Hence the drop has been quite substantial.

The yield on the TIPS is generally referred to as a “real “ rate of interest because the impact of the expected rate of inflation has been removed.  Thus, the difference between the “nominal” yield on bonds, in this case the 10-year Treasury bond and the yield on TIPS is considered to be the expected rate of inflation built into bond rates.

Given that the 10-year Treasury bond closed to yield 2.44 percent Wednesday afternoon, the expected inflation built into these market rates was a little over 2.2 percent.  Over the past year or so, with all the fluctuation in interest rates, the “expected” inflation that market participants included in nominal yields was relatively stable, remaining in the 2.0 percent to 2.2 percent range.

So, the variation in yields has primarily come because of the volatility of the “real” rate of interest, the yield on the 10-year TIPS.

The question that must be answered, therefore, is why is the yield on the 10-year TIPS jumping around as much as it is?

In the 20011 to 2013 period, the yield on the 10-year TIPS dropped to historically low levels and even dropped into negative territory.  I have explained this phenomenon in terms of international flows of money.

In essence, European financial markets experienced quite a scare during this time period.  A lot of “risk averse” money flowed out of Europe at this time and flow its way into the “safe haven” markets in the United States.  This massive flow of funds resulted in the extremely low yields that came about on TIPS.

In the spring of 2013, as events improved in Europe, this “risk averse” money began flowing back into the continent and, as a consequence, the yield on the 10-year TIPS rose back into positive territory and, as mentioned above, rose up to a range of 80 basis points to 90 basis points.

There are no major flows of money into the United States at this time.  Hence, we cannot use this explanation to discuss the substantial decline in this yield in recent weeks.  We need to look elsewhere.

In many economic models, economists contend that the “real” rate of interest is related to the expected real growth rate of the economy.  Hence, the “real” rate of interest should, in some way move in a direction that is consistent with what market participants believe to be the “expected” growth rate of the economy.

In late 2013 and early 2014, the markets seemed to be very confident that the rate of growth of the United States economy was picking up.  And, as this confidence was translated into the bond market the yield on the 10-year TIPS rose.  In face, most forecasts of rising long-term interest rates alluded to the fact that as economic growth picked up, the “real” rate of interest should rise.  And, if expected inflation remained constant, then nominal interest rates should rise because of the rise in the “real” rate of interest.

That is, analysts were predicting rising long-term interest because they were predicting more rapid rates of economic growth in the future.

But, now, some of this enthusiasm seems to be wearing off.  The economy just does not seem to be growing that much more rapidly and the economy in the second quarter of 2014 does not seem to be making up for the production that was lost in the first quarter due to weather related slow downs.  In effect, the earlier enthusiasm for a more robust economy seems to be fading.

It seems, therefore, that this re-adjustment of the expectations for the future growth of the economy is being transmitted to the financial markets.  That is, market participants are reducing the “real” rate of interest because their expectations of economic growth have fallen.

What this means, if market participants are correct, is that longer-term interest rates will not rise as much in the future as some analysts had originally projected.  It will be interesting to see if this occurs because in most business cycles, longer-term interest rates tend to rise, sometimes rather steeply, as the expansion continues.

However, here we are in the fifth year of the economic expansion and long-term interest rates are remaining at very low levels.  This seems to be just another sign of how weak this economic recovery really is.

Will longer-term interest rates rise?

In the above analysis, two reasons were given for rising long-term interest rates.  First, inflation can begin to increase and the “expectation” of future inflation built into market interest rates can begin to rise.  Thus, with no change in the “expected” real rate of interest, nominal interest rates would rise.  Right now inflation is running below 2.0 percent with little real indication that it is going to increase in the near future.  Therefore, we cannot expect nominal longer-term interest rates to rise for this reason.

Second, market participants can increase their expectations about the future rate of growth of the economy.  As mentioned above, market participants, right now, seem to be moving in the opposite direction.  And, if economic growth continues to remain tepid, at best, we cannot really expect too much boost in longer-term interest rates to come from rising expectations of economic growth.

Historically, the fastest economic growth to occur in a new recovery comes in the first several quarters after the recovery begins.  Being in the fifth year of the recovery indicates that we are far beyond the fastest growth rates.  Therefore, it would seem that we cannot expect too much rise in longer-term interest rates to come from a rise in market expectations of future economic growth.Conclusion: longer-term interest rates may stay lower than we had earlier predicted because the economy continues to remain very, very weak.

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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