A year since the dramatic “taper tantrum,” the bond market is again confounding skeptical investors — but this time with its persistent composure and calm.
In May of last year, Federal Reserve Chairman Ben Bernanke touched off a mini-panic in the Treasury market by describing his intention to gradually reduce the Fed’s pace of bond buying in response to firming economic conditions. In the harried anticipation of the “tapering” of the Fed’s quantitative-easing program, bond yields rushed higher, from below 1.7% early that month to 2.16% by May 31.
The benchmark yield reached 2.98% around Labor Day — a wild and painful velocity of selling for the world’s most liquid market. The 10-year ultimately peaked at 3.02% on Dec. 31, and since has eased back toward 2.60%.
From a wider view, the yield has spent more than 10 months lolling between 2.50% and 3%, upending popular expectations that yields would climb steadily higher and make bond investments treacherous. The consensus based this view on expectations of waning Fed support, a broad pickup in the world economy and a flow of investor dollars from bonds toward stocks. Of these firmly held premises, only the Fed’s well-telegraphed monthly reduction in bond-purchase volume has decisively come to pass.
A 'flummoxed' market
“The market is flummoxed,” says William O’Donnell, co-head of markets strategy at RBS Securities. Hedge funds continue to bet on higher rates by shorting Treasury futures, and fund-manager surveys continue to show dislike for bonds.
And yet a variety of powerful forces have kept real money flowing into bonds, and their persistence will likely act as a shorter chain anchoring yields at lower levels than accompanied past economic cycles.
Among the factors:
The strong rebound in equity markets got pension funds fully funded and topped up their allocation to stocks, leaving them hungry to lock in long-term yields to fund future obligations and stoking a strong appetite for longer-term debt. Insurance companies and foreign central banks have followed this path, too. And U.S. banks have also become aggressive buyers of Treasuries as they seek safe “carry,” or interest-rate spread, income.
In short, there hasn’t been much of a “great rotation” of cash from bonds into stocks, in large part because strong stock-market performance itself did investors’ rotating for them.
The persistent demand for yield is meeting a relatively constrained supply of “interest rate” available in the world. In some respects, as reported here in February, there is a “bond shortage.”
Meantime, stimulative Japanese central bank bond buying and the widespread belief that the European Central Bank is committed to backstopping sovereign debt markets on the Continent have compressed foreign government yields to levels below what almost anyone expected.
With German 10-year yields below 1.5% and those of Italy, Spain and Ireland beneath 3%, U.S. Treasuries just above 2.50% look like a downright cheap source of safe income by comparison.
Investors are coming around to Fed Chair Janet Yellen’s message that, after the Fed sunsets its QE program – perhaps by October, possibly later – it will still be a relatively long time before short-term interest rates are lifted. The important point of Yellen’s recent line of communication is that short-term interest rates will ultimately peak at far lower levels than in past “normal” economic cycles.
Michael Darda, strategist at MKM Partners, now forecasts short-term rates will be lifted only to 2% to 3% at this business-cycle peak, some years down the road, compared to 4% or higher in pasty tightening phases. In this respect, this cycle resembles those immediately after World War II, when long-term rates were rather steady at low levels for years on end. In the late ‘40s and ‘50s, benchmark Treasury yields peaked between 2.4% and 3.9%.
The U.S. economy’s perceived chances of surging toward “escape velocity” have diminished in recent months. The first quarter’s leaden 0.1% early reading on GDP means the math for getting to 3% for the full year has become challenging. This dampens fears that inflation pressures will build as economic slack is reduced quickly, and makes investors more comfortable owning bonds.
All this goes a long way toward explaining why rates have been suppressed, and why, in turn, corporate bonds and all other debt products have been enjoying huge demand. It doesn’t mean bonds are a great buy at these levels, or that rates won’t drift higher. But a surge in rates seems less likely than the conventional wisdom continues to hold.
O’Donnell believes 10-year Treasury yields will stay roughly in their recent range, meaning traders can lighten up on bonds near the current lower end of the range and look to buy as yields get closer to 3%. He thinks a likely, though fleeting, catch-up move in the Fed’s preferred inflation measure – personal consumption expenditures – this month could jar yields a bit higher. But he would view that as a chance for tactical investors to add a bit more exposure to Treasuries, which have so far refused to comply with those popular calls to throw another tantrum.