Why Haven't Bond Rates Risen?

Includes: AGG, IEF, TIP, TLT
by: John M. Mason


Longer-term interest rates have dropped since the start of the year when most analysts believed that they would increase.

The first quarter performance, weather affected, is one reason why these rates have not risen.

Turmoil in the world leading to international investors seeking a "safe" haven in the US is another reason.

Almost everyone I know and myself included believed that bond interest rates would rise this year.

Yet, the yield on the 10-year US Treasury bond traded at a little more than 3.00 percent on December 31, 2013 and now is trading around 2.60 percent.

What is going on here?

I am looking at two things here… the real rate of interest and expected inflation. This comes from decomposing the nominal rate of interest, assuming that the nominal rate is equal to the real rate of interest plus expected inflation.

As a proxy for the real rate of interest, I use the yield on the 10-year Treasury Inflation Protected Securities (TIPS).

Subtracting the TIPS yield from the yield on the 10-year nominal Treasury bond, one sees that the expectation that investors built into the nominal yield since December 31, 2013 has remained remarkably constant. Around the end of the year, expected inflation was about 2.30 percent. In early May, expected inflation was around 2.20 percent.

In terms of monthly averages, inflationary expectations averaged 2.23 percent in January, and 2.16 percent in February, March and April.

One can only conclude that investors did not really experience much change in inflationary expectations during the early part of this year.

Thus, the decline in nominal interest rates appears to be mostly centered in the drop in the real yield.

At the end of last year, the yield on the 10-year TIPS was around 75 basis points… 0.75 percent. In the first days of May, this yield had dropped to around 40 basis points… 0.40 percent.

So, the nominal yield dropped by about 40 basis points during the first four months of this year and 35 of the 40 basis points came from a drop in the real yield.

The question is… what caused this drop?

Well, economists tie the "expected" real yield to the expected real growth rate of the economy.

The United States came into the new year with some pretty hopeful projections of what the growth of real GDP would be. I was more optimistic than I had been for several years and even upped my forecast for 2014 to 3.00 percent.

The optimism for the first quarter dissipated as the weather was very disruptive and preventative. As almost everyone knows, the numbers for the first quarter were not really encouraging. Analysts have been arguing that there will be some "catch-up" in the second quarter, as people make expenditures that were delayed from the first quarter.

Still, expectations for economic growth do not seem to be as exuberant now as they were at the end of last year.

There is a second factor that we have to consider. Many people feel that there have been some international flows of risk-averse funds from eastern Europe… and elsewhere… into "safe" US Treasury securities.

There is precedent for this over the past three years. I have written a great deal on the time period when the yields on TIPS were actually negative. It was my belief that these TIPS yields turned negative because of the massive flow of funds coming from European investors that were highly risk-averse during the financial problems experienced in the continent during the 2011 to 2013 time period. Most of this risk-averse money went either to Germany… whose 10-year bond yield reached a low of 1.20 percent… and the United States.

The yield on the 10-year TIPS did not return to positive territory until these funds began to return to Europe. One could also see the yields on European sovereign debt drop as the yield on the 10-year TIPS rose.

There are also other reasons for funds to flow into "safe" US Treasuries. There are economic problems in the emerging nations as well as in Russia and China.

The interesting thing is that as things seriously worsened in the Ukraine, the yield on the 10-year TIPS plummeted. On Wednesday, April 30, this yield closed at 0.505 percent. On Thursday, May 1, the yield dropped to close at 0.405. It has closed around 0.400 percent the past two days.

Thus, the nominal yield on the 10-year Treasury security has dropped by about 40 basis points this year when it was expected to go higher.

My conclusion is that the yield is lower because people are anticipating a lower rate of growth for the US economy than was the case at the end of the last year and because of international flows of funds seeking a "safe" haven in the United States.

When will longer-term interest rates begin to rise again?

When expectations about the strength of the economy are revised upwards. However, I do not expect that economic growth will become that much more expansive this year.

Or, when the flow of international funds is reversed as events become calmer in the world.

What about the tapering that the Fed is doing? My expectations are that the Fed's actions will only impact longer-term interest rates as the monetary policy of the Fed can create faster economic growth. And, as readers of my blog know, I believe that the Fed has very little impact on the growth rate of the economy at this stage in the credit cycle.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.