Low bond yields are driven by fundamentals, not a bubble
A dramatic drop in US yields over the past few months has fuelled talk that a bubble is forming in the Treasury market. While government bonds may be overbought on a technical basis, we think they are correctly reflecting the risks of weak growth and very low inflation in the US economy, keeping interest rates low for a long time. We believe these themes will persist for at least the next one to two years, and further falls in inflation are likely to push bond yields even lower. What’s more, continued fears over a second US recession could add additional downward pressure on Treasury yields, even if they eventually prove unfounded.
Yields on 10-year US Treasuries briefly dipped below 2.5% in late August, and were recently trading around 2.6-2.7%. These yields have been steadily falling for the past 28 years, trading in a clear downward trend. In fact, whenever yields have hit their 10-year moving average, currently 4.26%, this has been a buying opportunity, with yields subsequently falling (yields move inversely to prices). Whether looking at 10-year moving averages or other shorter-term measures of momentum, Treasury yields are at the lower end of their trading range, suggesting they are overbought on a technical basis. But they can stay at these levels for some time in a period when growth and, especially, inflation is decelerating.
The Commodities & Futures Trading Commission’s (CFTC) data on speculative positions shows a current neutral stance. While net short positions, where investors express a negative view by selling securities they don’t own, have recently been unwound, they have yet to turn long, or positive. Meanwhile, the latest (August) Merrill Lynch Fund Manager Survey shows that fund weightings in US Treasuries are within normal historical ranges relative to the benchmark. So there is little evidence that speculative demand is pushing Treasury yields lower.
Core inflation (plus a risk premium based on the volatility of headline inflation), has historically been a useful measure for long-term bond valuation. It suggests fair-value for 10-year yields is currently between 2.8% to 3.3%. But we expect core inflation to fall, given the large amount of spare capacity in the US economy, and will discuss this view in more detail in a subsequent Daily Theme. Lower inflation would also reduce fair-value yields. We believe that markets have yet to fully price this in, or the extent to which interest rates will stay low for longer, and further declines in bond yields are thus likely.
In the next few weeks, a lot will depend on where economic data releases come out relative to consensus views. Until the past week, recent economic data had been much weaker than expected, which now means there is a low bar to beat expectations and trigger a move up in yields. But on a six- to 12-month horizon, weak inflation and a continuation of ultra-low interest rates are likely to keep downward pressure on US bond yields.
In the years to come, Treasuries could yet be vulnerable to concerns about high government debt levels, similar to those that have caused a spike in Greek bond yields. However, in the short-to-medium term a Republican victory in the November US mid-term elections should also potentially limit President Obama’s ability to push through a large, deficit-boosting second stimulus. More importantly, we believe demand for Treasuries will remain solid for several reasons.
First, the status of the US dollar as the world’s reserve currency provides Treasuries with a solid base of foreign demand, and bond vigilantes have weaker and much less liquid bond markets to focus their attention on first, such as peripheral Europe. Meanwhile, US household holdings of Treasuries are close to historically low levels, suggesting room for increased demand from these domestic sources as well. Finally, we believe further substantial domestic bond purchases are likely as the US Federal Reserve responds to the deflationary threat.
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