In December 2014, the 10-year yield was expected to trade within a 100 basis point trading range with a low yield of 2.00% and a high yield of 3.00% for 2015. It did not take long for the lower yield level to be broken. With 20-20 hindsight, the yield levels should have been set lower at 1.50% to 2.50%. This is what I wrote:
2015 is expected to see a 100bps trading range of between 2.00% to 3.00% for the 10-year yield. The decline in crude oil and other energy prices is seen offering the potential to drive interest rates lower should inflationary pressures moderate or turn into deflationary pressures.
Since 10 December 2014, the WTI crude oil spot price has declined 26.5% (see chart below). Given the decline in bond yields and the price of oil, it would appear that bond investors' fear of deflationary pressures has increased.
Long-term bond prices measured by PIMCO 25+ Year Zero Coupon ETF (NYSEARCA:ZROZ) have increased 14.23% year-to-date and 52.15% for the trailing 1 year. The iShares 7-10 Year Treasury ETF (NYSEARCA:IEF) has increased 3.76% year-to-date and 8.51% for the trailing 1 year.
The flattening of the yield curve is sending a message. At year-end 2014 the 30-year less 1-year yield spread was 250 basis points with the 30-year less 10-year yield spread at 58 basis points. On January 28, 2015 the 30-year less 1-year yield spread was 212bps, with the 30-year less 10-year yield spread at 56bps. The 30-year yield closed at 2.29%, 10-year yield at 1.73% and the 1-year yield at 0.17%. Longer-term interest rates have fallen more than shorter-term interest rates. One view of a flattening yield curve is economic weakness on the horizon as the Federal Reserve hikes short-term interest rates to slow economic growth. The Federal Reserve has suggested that they may increase the federal fund target rate currently in the range of 0bps to 25bps.
History has seen the Federal Reserve maintain a 1.00% discount rate for nearly a decade. The current discount rate has been 0.75% since January 2010. See the charts below.
The surge in short-term interest rates during 1937 resulted in a recession.
Short-term Treasury yields increased and general business conditions collapsed in the late 1930's.
Velocity may have begun a bottoming process, as shown in the chart below.
The long-term trend of velocity has been down.
Velocity and year-over-year change in the PCE tend to trend in the same direction.
The 10-year yield has fallen lower than the level expected. It does not matter if the reason is fear of deflation, a rush to liquid assets, or a fear of the economic and political unknown. What matters is that investors have become highly risk averse with the placement of monies in bonds that offer little in the way of an income return.
The fact that investors seem to prefer bonds to equities creates an economic catch-22. The lower interest rates fall, the better the fixed income performance. Better performance attracts more funds to the asset class as investors chase past performance. Chasing performance is a worry.
The concern is that the Federal Reserve is pushing on a string. That lower interest rates result in greater savings with businesses focused upon cost cutting rather than expanding. Consumers and businesses might be holding elevated levels of desired cash balances over concerns that credit lines could be reduced or eliminated as happened during the past economic downturn. This can hamper the velocity of money and economic activity.
Economic thought of the day:
The commodity sector, iron ore and crude oil, seems to be engaged in a game of chicken. The first to reduce output helps a competitor obtain a better price. For this reason, output is not reduced. At some point, only the very strong will survive. This may make economic growth more of a challenge as investors fear the loss of capital and invest in a risk averse manner.
Let me know what you think of the article. Happy trading.
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