There were a lot of uncertainties for investors and their advisers at the start of 2014. The only thing nearly everyone was certain about was that long-term interest rates were heading up and bond markets were heading down.
In fact, as every fund manager is now painfully aware, yields have fallen in most developed markets since the start of the year. Ten-year yields in the US are now about half a percentage point lower than at the end of 2013.
Around the world, everyone is asking themselves the same two questions: first, should I worry about what these low yields are telling me about the state of the US economy? And second, should I expect them to last?
My answer to the first question is the bond market is telling us something about the recovery, but nothing we did not know at the start of the year. My answer to the second is that yields are going to be lower than usual for a long time to come, but not nearly as low as the futures market now seems to expect.
As long as most developed countries have a lot of spare capacity built up from the past few years of stagnation, we can expect rates to be lower than they have been at the same stage in past recoveries. But there is nothing going on in the real economy to suggest we should be a lot gloomier than we were a few months ago.
Flight to safety?
You could say the same about inflation: a sharp fall in inflation expectations would justify lower nominal bond yields. But in the US, at least, inflation has been going up.
So what has happened to yields does not seem to have much to do with the level of demand and supply in the economy. But it does seem to have a lot to do with the demand and supply for US Treasuries and other “safe” sovereign assets at a time when financial institutions are under pressure to “de-risk” their balance sheets and the US federal deficit is falling like a stone.
The smart money was so focused on the Federal Reserve “tapering” its purchases of US bonds, it failed to spot the US Treasury was tapering its borrowing even faster. Investors probably also underestimated the continued demand for bonds coming from pension funds rebalancing their portfolios after another year of double-digit returns on equities. Regulatory pressure has pushed US banks in the direction of holding a lot more government debt on their balance sheet since the financial crisis, and now European banks are starting to following suit.
So, there are good structural and technical reasons why yields have fallen this year, some of which could take time to reverse themselves. That suggests we are in a world of lower real interest rates. But that does not mean they can stay as low as the market now seems to expect.
The real interest rate on 10-year US Treasuries averaged close to 2 per cent before the financial crisis. But futures contracts are currently pricing in a 10-year real rate below 1 per cent for the next three years and not going over 1.5 per cent at any point in the next decade.
That is possible. But I don’t think it is consistent with even the most mediocre of US economic recoveries – and the one we are seeing today is a bit better than mediocre, even if it is not great.
On the supply side of the equation, it is also worth noting that we are now close to the low point when it comes to the supply of US Treasuries. After falling very sharply, the US federal deficit is going to level off in the next year or so and the volume of bonds issued is about to go up. So that short-term reason for rising bond prices is likely to recede.
It is the way of the world that markets are “surprised”. If there were no surprises, there would be barely any movements in prices at all. But having been surprised by falling bond yields in the first half of the year, it really should not come as a surprise to anyone if they quite soon start to creep up.
Stephanie Flanders is chief market strategist, UK and Europe at JP Morgan Asset Management