Stock market veterans are concerned that these declining rates presage a bear market in stocks as investors purportedly sell stocks and rush to safety. These concerns, however, may be misplaced. Falling rates may simply be a by-product of the Fed's continued firm grip on rates which has not yet petered out.
How could that be now that the Fed's taper is in full swing? The short answer is because the Federal Reserve has not cut back on bond purchases as quickly as the Treasury has cut back on their issuance.
Treasury bonds are issued to finance government spending to the extent that it exceeds tax revenues. As the budget deficit declines, so does the issuance of Treasuries. When the US budget deficit briefly breached zero under Bill Clinton, for instance, issuance of 20-year Treasuries dried up, causing a good bit of panic amongst Treasury bond investors who had come to rely on these instruments.
The US fiscal deficit has fallen from 7% of GDP in 2012, when Quantitative Easing was instituted, to 3% currently. In dollar terms, that is a decline from $1.1 trillion to $500 billion.
Consequently, Treasury issuance to finance the deficit has also dropped 55%. In contrast, the Fed's purchases of Treasuries during this time period have fallen only 44%, from $45 billion per month initially to $25 billion per month currently. Consequently, Fed purchases of Treasuries today represent a larger percentage of new Treasury issuance than when QE was launched.
At a rate of $300 billion per year, the Fed currently consumes 60% of all new Treasuries issued, compared with approximately 50% when the program was initiated in September 2012. It is perhaps no surprise, therefore, that after an initial upward spike from 1.9% to 3.0% when the taper was announced in June of 2013, 10-year Treasury rates have steadily declined back down to 2.5%.
That won't last. Going forward, at the current trajectory of a $5 billion reduction in QE Treasury purchases per month, the taper should be finished in five months. The budget deficit is not likely to go to zero in that time, although at its current rate it could approach zero in a couple years with very positive effects on the US economy, finally enabling the US to afford to raise short-term rates back to normal.
As we thus rapidly approach a full cessation of Fed Treasury purchases and a continued healthy supply of new issuances, 10-year Treasury rates will likely be driven more by market forces in the second half of the year. An upward rate bias is likely if for no other reason than because the downward pressure on rates from Fed QE purchases will go away. The shorts who recently exited their positions on 10-year Treasuries (NYSEARCA:IEF) may be throwing in the towel at just the wrong time.
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. I have no business relationship with any company whose stock is mentioned in this article.