The Road to Higher Bond Yields is Still Under Construction

July 2011

Something unexpected happened on the way to those rising interest rates that once were considered a fait accompli.

Investors riding the Treasury yield northbound hit a series of detours so mazelike that even their economic GPS systems were of little navigational help.

Not that they're complaining, but the recent decline in long-term rates — which pushed bond prices higher — was not on this summer's itinerary.

Ever since the Great Recession ended two years ago, fixed-income investors have been on red alert for inflation and the higher interest rates that usually accompany a rebounding economy.

Their concerns were based on conventional economic theory: Stimulus spending by the federal government and an easy monetary policy from the Federal Reserve would boost the demand for goods, services and workers.

But amid the post-crisis financial landscape, the American economy may have gotten in the wrong lane, perhaps even headed in the wrong direction.

"Long-term interest rates usually behave pro-cyclically," noted Northern Trust's chief economist Paul Kasriel. "They move up as the economy gathers momentum and move down as growth decelerates."

Kasriel makes a distinction between the benchmark short-term interest rates set by the Federal Reserve (the Fed funds rate) and the longer-term bond yields established by market forces.

Greek crisis
For a while, bonds behaved as expected in the aftermath of a recession. Though the Federal Reserve kept short-term interest rates near zero to ward off deflation, yields on 10-year Treasuries started rising more or less on cue after bottoming at just over 2% during the darkest hours of the financial crisis.1

By the early spring of 2010, the benchmark Treasury yield had doubled to 4%.2

That's when the expected smooth move upwards in interest rates became much bumpier.

First, a sovereign debt crisis in Europe had investors looking for a roadside oasis. Treasury yields plunged by one and a half percentage points over the next five months to 2.5%3 as Greece teetered on the brink of default.

Fearing a double-dip recession, Fed Chairman Ben Bernanke in late August telegraphed the U.S. central bank's intention to undertake a second round of quantitative easing, dubbed QE2, or the buying of Treasury debt with newly minted money.

But what initially looked like the on-ramp to still-lower rates — all things being equal, increased government demand for Treasury bonds should raise their price and lower their yield — turned into yet another circuitous detour.

As it turned out, all things weren't equal.

"The perception that QE2 would stimulate growth caused investors to sell bonds and buy economically sensitive assets like stocks and commodities," said Colin Robertson, managing director of fixed income for Northern Trust. "The asset allocation shift overwhelmed the impact of the Fed's government bond purchases."

The exodus from fixed income to equities sent bond yields rising again, with the 10-year Treasury eventually hitting 3.75% in February 2011.4 But then, with the bond bears warning of still-higher rates, the trip north took yet another unexpected twist.

With the Fed's QE2 buying program set to end at mid-year, all things being equal, reduced demand for Treasury bonds would be expected to weaken their price and raise their yield. Instead, a steady stream of disappointing economic data suggested that the U.S. recovery was cooling. This turned into yet another detour as investors again reversed course, this time selling stocks and buying bonds.

Down went government bond yields, this time falling by three-fourths of a percentage point to under 3% by this June.5

Hitting the wall
To Kasriel, the recent decline in yields is sending a clear message.

"The economy is decelerating," he said. "It's especially unnerving that growth is waning even before the Fed has taken its foot off the monetary gas pedal. That does not forecast well for growth over the second half of the year."

But it might suggest that bond yields, even after their recent drop, could go lower still, thus further boosting the valuations of many fixed-income assets.

Few economists expected the recovery from the worst financial crisis in 80 years to follow a normal trajectory. Virtually without exception, historically, the popping of credit bubbles in rich and poor countries alike have triggered strong economic headwinds that restrained economic growth and employment for years to come.

Still, the inability of the U.S. economy to achieve its trend growth rate of around 3% per year is disappointing, especially in light of the massive doses of fiscal and monetary stimulus used to assist the effort. If the recovery is faltering barely two years after it began, investors need to know why in order to better gauge the inflationary or deflationary risks ahead.

Deflationary psychology
A key reason for the economic slowdown has been this year's trend of rising food and gasoline prices that served to undercut discretionary spending and consumer confidence. Though supply-chain disruptions from Japan's earthquake and tsunami also played a role, chronic weakness in house prices is at the heart of the problem.

"The recovery in residential housing is seriously lagging investors' very tepid expectations. This is hurting consumer sentiment and hampering a return to profitable lending by financial institutions," Robertson said. In fact, he doubts that the U.S. economy can return to normal growth and employment until housing prices recover.

So with Uncle Sam nearly out of fiscal options, might there be a QE3? And if so, what would that mean for inflation — and for interest rates?

"If the current slowdown turns out to be more than just a temporary soft patch, then another round of quantitative easing is likely, though maybe not until early next year," predicts Kasriel. "There's strong opposition to more monetary stimulus in Congress and from some Fed officials, so Bernanke would have to see unmistakable evidence of deflation or that the economy has decelerated to near stall speed before advocating another round."

Despite the extraordinary fiscal and monetary stimulus, the inflationary spike that bond investors feared has yet to materialize, especially when the volatile food and energy sectors are stripped out of the calculation. Of course, Americans need food and energy to live, and the recent price rises in those sectors have been painful.

But most Fed officials don't view commodity prices in a purely economic context because weather and geopolitical factors also play key roles. In any case, so-called core inflation remains tame.

Equally important, there's scant evidence that consumers expect the recent uptick in headline inflation to remain a lingering problem.

That last point is critical, since the Fed monitors inflationary expectations as carefully as inflation itself.

Not to worry, assured Robertson, who noted that "inflation expectations in the market are relatively modest and consistent with an interest rate structure that can remain stable or move even lower." He does not expect an increase in the Fed's policy rate until 2013, at the earliest.

Idling in park
Investors are trying to understand why the loose fiscal and monetary policies haven't caused inflation and inflationary expectations to take off.

Not surprisingly, context matters — a lot.

The credit bust that caused the financial crisis created an economic backdrop that is different from most recessionary periods since World War II.

Consumers remain deeply in debt, businesses are more reluctant to hire, and banks are more hesitant to lend.

Though corporate balance sheets are reasonably strong, productivity gains have allowed employers to keep workforces lean. With joblessness around 9%, workers lack the leverage to negotiate higher wages and benefits, a major driver of inflation.

Also, the nation's factories are operating well below full capacity, thus minimizing the production bottlenecks that can lead to higher prices.

The bottom line: Despite the massive liquidity created by the Federal Reserve, much of it remains untapped on bank balance sheets. And that's before the Federal Reserve begins normalizing interest rates, first by ending quantitative easing, then by no longer reinvesting the coupons and proceeds of maturing assets held on its balance sheet and finally by raising benchmark interest rates from near zero.

All those factors should withdraw liquidity from the financial system, further dampening any risk that rapid, excessive credit creation could lead to higher inflation.

From a growth perspective, this worries Kasriel, who noted that the modest level of credit creation in recent months could slow to a trickle or even reverse over the last half of the year as fiscal and monetary policies inevitably tighten from their recent, exceptionally easy levels.

"That is not a recipe for higher inflation," he said.

Which is good since inflation is a bondholders' primary worry. Besides eating into the purchasing power of their income streams, inflation causes the value of existing bonds to decline, especially longer-dated maturities. Inflationary spikes are especially damaging to bond prices over the short term.

But if core inflation moved only gradually higher and rates followed, it would not necessarily trigger a long- term bear market for buy-and-hold bond investors.

Between 1953 and 1981 — a period of rising inflation, especially near the end — the 10-year Treasury yield jumped from under 3% to more than 15%.6 Yet during that same quarter-century, intermediate-term U.S. government bonds produced an annualized return of 4.4%, matching the inflation rate.7

Though the inflation outlook is stable at the moment, Robertson knows that things change. He's keeping a close watch for traffic merging from the left and the right, even as he dodges orange traffic cones and navigates multiple detours amid a lingering economic storm.

"If we see a QE3 coming at us, that would be a strong signal to shorten maturities to minimize interest rate risk," he said. "Eventually interest rates and bond yields are likely to move higher, but it's all a matter of timing."

In other words, we'll get there when we get there.

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1 Federal Reserve Board
2 Federal Reserve Board
3 Federal Reserve Board
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6 Federal Reserve Board
7 "The Specter of Rising Interest Rates." April 19, 2011. Northern Trust.
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