In my opinion, the Federal Reserve System has been given more credit than it is due concerning how low long-term Treasury securities had fallen in the past year or so.
The research I have seen during my professional career has shown that the Federal Reserve, from time-to-time, has attempted to influence the yield on long-term Treasury issues but has never been very successful, either in terms of the its ability to lower long-term yields by much or in terms of keeping them lower for an extended period of time. This is not true, however, of short-term yields. I continue to believe this.
The yield on the 10-year Treasury security has been extremely low for several months now. Around the end of July 2011, the yield on the 10-year was about 3.00 percent. It dropped precipitously after that time, falling around 2.10 percent by August 18 and then falling below 2.00 percent the second week of September.
Since then, this yield has fluctuated between approximately 1.80 percent and 2.10 percent until last week (except for a three day bump up right at the end of October).
The most interesting move during this time period, however, has been the move into negative territory of the 10-year TIPS bond. At the end of July 2011 the 10-year TIPS was trading around a 0.50 percent yield (which was already low historically). On August 10 the yield had become negative, trading around a -0.155 percent yield. That is, we had a negative real rate of interest.
For a good portion of the time since then the yield on the 10-year TIPS has been negative. Yesterday, this issue closed at -0.056 percent yield. The reading on this behavior? The movement into Treasury securities this summer was a “flight to quality” and was not a result of the actions of the Federal Reserve System.
The Federal Reserve cannot force interest rates…long-term or short-term…below a zero interest rate. The Fed has been very successful in keeping its target rate of interest, the Federal Funds rate near zero, but admits it cannot force this rate below zero.
Why would investors invest in something that had a below-zero interest rate on it? The basic reason is that these investors wanted to invest in Treasury securities…regardless of the yield. This represented a “flight to quality” and the movement of funds affected the yields on all long-term Treasury securities.
One should note that with all the liquidity available to the financial markets, the spread between US Treasury issues and Aaa Corporate bonds rose during this time. You do not find this type of behavior taking place except in times when there is a flight to quality. One should also note that there was also a “flight” to German sovereign debt at this time as the yield on the 10-year German government issue fell, although not by as much as did the yield on the US Treasury issues.
The movement in Treasury yields last week was a movement back into riskier assets. This is confirmed in a New York Times release this morning concerning the actions of hedge funds:
A good deal of the recent flight from U.S. Treasuries has been driven by hedge fund selling…
Last week was the biggest weekly decline for U.S. Treasury prices since last summer. The big sell-off in government debt pushed yields to their highest levels in more than four months. It was a sign investors see less need to put money in Treasuries for safekeeping now fears of a messy Greek debt default are fading and the U.S. jobs picture looks brighter.”
This, to me, makes much more sense than does the argument that this movement is the beginning of the bear market in bonds. Also, as the yield on 10-year Treasury securities rose last week the yield on 10-year German bonds rose as well.
Long-term yields will begin to rise at some time in the future but I don’t believe that we have reached that stage of the cycle at this time. The bond market still needs to re-position itself to risk-based assets and reduce its need for a “safe haven.” This will continue, I believe, for the short-term.
I think that the yield on the 10-year Treasury needs to return to above 3.00 percent and the yield on the 10-year TIPS bond needs to get back up into the 0.50 percent to 1.00 percent range. This will restore some of the relative yield spreads to levels that are more consistent with current economic conditions.
These yields will begin to rise along with economic growth as the economy picks up steam. However, I don’t see that there will be much “steam” in the next three or four quarters.
Furthermore, the Federal Reserve will continue to err on the side of ease until the economic recovery does appear to accelerate. Although Fed ease will not hold down long-term interest rates once they begin to climb on any experienced economic pickup, the Fed wants to avoid disruptive bank failures or other surprises that might occur on the path to recovery.
Of course, we could always have another situation in which a further “flight to quality” would cause long-term Treasury yields to drop. Greece is not out-of-the-woods yet, and there is still Ireland, Portugal, Spain, and Italy to deal with.