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Short And Sharp: The Bond Market's Ir/rational Response

Jul. 06, 2017 4:47 PM ET

By Seema Shah

Bond markets can sometimes come across as irrational, and the last few weeks may be a perfect demonstration of this. Three weeks ago, 10-year U.S. Treasury yields declined in response to the U.S. Federal Reserve's (Fed) projection that policy rates would be raised several more times over the next 18 months and the Fed's signals that they'll soon begin reducing the size of their balance sheet. This slightly unusual reaction reflected the bond market's fear that the Fed's tightening path would harm U.S. growth prospects. Then, last week, it took just a few hawkish words from the European Central Bank (ECB) and the Bank of England to trigger a sharp bond market sell-off… on both sides of the Atlantic.

Which reaction was the "rational" one?

If I had to pick, I would say that the second reaction - the sell-off - was the more rational. After many years of near-zero policy rates and balance-sheet expansion, I believe that the global economy is strong enough to withstand a removal of monetary policy stimulus. Inflationary pressures are confusingly subdued but, with labor markets so tight, I buy into the Fed's thesis that it is just a matter of time before upward price pressures emerge. Therefore, raising rates is no policy error.

And so, all it took was a few unexceptional words from ECB President Draghi ("deflationary forces have been replaced by reflationary ones"), and from Bank of England Governor Carney ("some removal of monetary stimulus is likely to become necessary if the economy remains firm") to trigger a bond market sell-off in Europe, which then rapidly spread to the United States and around the globe.

Ten-year U.S. Treasury yields are back to where they were in mid-May. But, at 2.35% (as of Tuesday 4th July), I think they have higher to go.

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The Principal Financial Group (The Principal®) is a global investment management leader offering retirement services, insurance solutions and asset management. The Principal offers businesses, individuals and institutional clients a wide range of financial products and services, including retirement, asset management and insurance through its diverse family of financial services companies. Founded in 1879 and a member of the FORTUNE 500®, the Principal Financial Group has $519.3 billion in assets under management1 and serves some 19.7 million customers worldwide from offices in Asia, Australia, Europe, Latin America and the United States. Principal Financial Group, Inc. is traded on the New York Stock Exchange under the ticker symbol PFG. For more information, visit www.principal.com. Insurance products issued by Principal National Life Insurance Co (except in NY) and Principal Life Insurance Co. Plan administrative services offered by Principal Life. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities offered through Princor Financial Services Corp., 800/247-1737, Member SIPC and/or independent broker/dealers. Principal National, Principal Life, Principal Funds Distributor, Inc. and Princor® are members of the Principal Financial Group®, Des Moines, IA 50392. Investing involves market risk, including possible loss of principal.

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