Many investors have wondered why Treasury yields have remained so low in 2014, particularly with unemployment falling, U.S. equity markets hovering near record highs, and the Fed tapering its purchases of U.S. government securities. Following 2013’s sharp rise in yields, the 10-year Treasury started 2014 yielding just over 3.0%, but has settled within a range of 2.5% to 2.8% since early February.1
At the beginning of the year, our outlook asserted that another significant rise in Treasury yields was unlikely in 2014 (see Viewpoints article Healthy outlook: year-end business cycle update). This view was founded on the premise that last year’s backup in interest rates resulted in a very steep yield curve—a signal that the expectations of Fed tapering and a solid U.S. economy in 2014 had already been priced into the market. These expectations were largely consistent with our outlook, and we believed that another surge in yields would likely require either better-than-expected U.S. economic growth or earlier-than-expected Fed rate tightening, neither of which appeared likely. Our outlook further stated that rising global risks and the potential for heightened market volatility would help offset upward pressure on yields.
Accordingly, we think still-low bond yields can be explained largely by economic fundamentals. First, U.S. economic performance has been disappointing so far this year, mostly due to severe weather conditions during the first quarter. Second, global inflation remains muted, as the eurozone struggles with deflationary pressures and slowing growth in China weighs on many commodity prices. Third, monetary policies in most developed countries continue to anchor short-term rates at extraordinarily low levels. Lastly, this global confluence of relatively slow growth, muted inflation, and low rate policy has contributed to low bond yields around the world. In fact, U.S. government bond yields are relatively high compared to those of counterparts in other developed economies, and this relatively attractive profile for global investors may have fueled demand for Treasuries and thus helped tamp down U.S. yields (see chart, right).
Other factors may also be at work. Rising geopolitical risk stemming from Russia’s actions in Ukraine may have boosted flight-to-quality demand for U.S. government bonds. Treasuries may have also benefited from technical factors, including purchases by China’s central bank to help manage its foreign currency reserves, corporate pension funds increasing exposure to long-term bonds to immunize long-term liabilities, speculative investors already being short Treasuries on a net basis, and a slowing new supply of Treasury issuance due to the declining U.S. budget deficit.
We believe the long-term relationship between interest rates and gross domestic product (GDP) growth suggests the 10-year Treasury yield will ultimately trend toward its equilibrium level, which aligns with our secular forecast for nominal GDP growth in the 4% range. But, in order for long-term rates to move sharply higher in 2014, the U.S. economy will likely need to significantly exceed near-term growth expectations or experience a rise in inflation, neither of which represents our base-case scenario. From an investment standpoint, high-quality bonds remain negatively correlated with stocks and continue to offer protection against equity-market volatility. The steep yield curve provides higher potential returns relative to cash, in addition to return opportunities in the intermediate-term range from the possible price appreciation these securities may experience as they “roll down” the yield curve --move closer to their final maturity dates. Although yields will presumably head higher as the business cycle matures over the next 12 to 18 months, a sharp rise remains unlikely anytime soon.
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