Here's why the Treasury market continues to confound conventional wisdom.
The U.S. economy is expanding—labor markets are showing strength, consumer sentiment is at an eight-year high—yet Treasury yields continue to fall as demand for bonds goes undeterred. That may seem counterintuitive in an era of record-breaking rallies in the U.S. stock market, but apparently there are plenty of reasons to hold on to your bonds, according to the experts.
So far this year, yields on 10-year Treasury notes have slipped nearly a full percentage point, or about 30 percent.
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Net asset inflows into several bond ETFs during that time have been strong. The iShares Core U.S. Aggregate Bond (AGG | A-98), which allocates nearly 40 percent of the portfolio to Treasurys, and the long-dated Treasury fund iShares 20+ Year Treasury Bond (TLT | A-83), for example, have gathered more than $6 billion and $2.8 billion, respective, year-to-date.
Their performances speak to the brewing rally in bonds, as the chart below shows:
In a broad sense, the demand for the safety of U.S. debt makes sense if you consider that the U.S. economy is resilient relative to many other developed markets today. But what’s driving this latest downward turn in 10-year yields? The short answer? Plenty.
From dropping oil prices, to concerns about the global economy, to growing risk aversion in the face of a looming U.S. stock market correction, to a lack of “fiscal policy leadership” here—there are many factors experts say are weighing on U.S. yields. Consider four drivers:
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Rates Could Go To 1 Percent In 2015
DoubleLine’s Jeff Gundlach this week said he would not be surprised to see 10-year yields slip to 1 percent next year—it’s at 2.10 percent today—if for no other reason than the simple fact that the majority of developed-market comparable Treasury yields are at 1 percent or below today.
“The 10-year Treasury could join the Europeans and go to 1 percent. Why not? The European rates are at 1 percent. France is below 1 percent right now,” Gundlach said in a webcast, as reported by Reuters. “What’s really an emergency level is the negative yield on the German two-year. When you get yields at negative, basically people are so afraid that they are willing to pay you for the safekeeping of their principal.”
Mohamed El-Erian said in a recent interview with Fox News that ongoing central bank interference and weak growth in places like China, Japan and Europe are creating head winds for the U.S. economy.
These head winds spell volatility ahead, and could cause investors to “take some money off the table.” In a similar vein, Bill Gross, in his December commentary, suggested similar trouble ahead for equity markets, and a need to rethink risk.
“There is an ongoing process of discovery taking place amongst the world’s central bankers which they hope will rejuvenate their respective economies without creating the inflationary horror of the 1970s,” Gross said in the comments posted on Janus’ website.
“Economic theory might suggest that artificially low interest rates gradually, but inevitably, lead not to more consumption and real growth, but to more savings in order to meet future liabilities such as education, health care and eventual retirement,” he said.
Lack Of Fiscal Policy Leadership
There are multiple reasons for a drop in U.S. yields, all somewhat related to the main narrative that the U.S. is further along in recovery from its 2008 balance-sheet recession than most other regions, John Forlines, CIO of JAForlines Global, told ETF.com in an interview.
“The bond market is not always reliable in predicting expansions and contractions, but it is pretty good in providing current market narratives,” he said. “It is telling us right now that the global economy is weak and that the big, traditional locomotive—the U.S., even in its relative strength to rest of the world—is not strong enough to pull everyone else along.”
Part of the problem as he sees it is a lack of “fiscal policy leadership in the U.S.—no Federal budget since 2009, no tax reform, no significant infrastructure investment, etc.”
That leadership is crucial in providing clear guidance—and fostering confidence—among investors.
What's An Investor To Do?
“Markets are reaching the point of low return and diminishing liquidity,” Bill Gross said in his commentary. “Investors may want to begin to take some chips off the table, raise asset quality, reduce duration, and prepare for at least a halt of asset appreciation engineered upon a false central bank premise of artificial yields, QE and the trickling down of faux wealth to the working class.”
There are certainly myriad views on what investors are to do about their fixed-income allocation, but one common thread is recurring in these views, and that is that when it comes to bonds, being tactical is increasingly important.
“Unless the economy slows dramatically, the initial effect of slowly rising short rates will not be the death knell for high yield and its kin,” Forlines said in a recent ETF Report article. “Those most exposed will be short-term bond and AAA-rated debt holders who hold no government debt or few high-grade bonds to offset the basis risk of rising short rates.”
“Tactical allocations are very important in 2015, because what will crater the long end of fixed income and then equities will be the discounting of a snuffed-out growth phase,” Forlines said.
Anthony Parish, VP of portfolio strategy at Sage Advisory Services, meanwhile, makes a case for what he calls “Goldilocks economy”—not too hot, not too cold—where economic drivers will come to the forefront, calling for tactical shifts in exposure as the picture becomes clearer.
“The Fed’s influence on the markets is diminishing, with progressively greater influence coming from the traditional macro drivers such as economic growth, inflation, jobs, housing, etc.,” Parish said in the ETF Report article. “This is a good development, because it gives us a clearer picture of the investment landscape that’s been fogged by Fed policy in recent years.”
For the moment, Parish said his firm is keeping durations “not too short and not too long.”
