Last December, I made another suggestion to watch bond yields in 2019.
I had made a similar suggestion in December 2017, and must admit that the movement in yields in 2018 completely surprised me.
Well, here we are, three quarters of the way through 2019 and I feel somewhat the same way as I did last year. In December 2018, I would never have imagined that bond yields would have performed the way they have this year.
On December 31, 2018, the 5-year US Treasury note closed to yield 2.510 percent. The yield on the 10-year US Treasury note was 2.683 percent. By the end of the second quarter of the year, the yield on the 5- year note was 1.765 percent, while the yield on the 10-year note was 2.002.
Now, we have finished the third quarter of 2019 and the 5-year yield stands at 1.585 percent, down almost 93 basis points from the end of 2018, and the 10-year yield rests at 1.671 percent, down just a little over 100 basis points.
What changed during this time period? What seems to have caused a decline of this magnitude at this time?
The timing seems particularly unusual for such a drop in yields, because the economy is in its eleventh year of expansion. True, the rate of expansion has been rather tepid by historical standards, but the fact is, the economy is expanding and has been expanding for quite some time.
Usually, interest rates would be going up at this time, not declining. Strange…
One reason why nominal interest rates are expanding at this stage in the economic cyclical is that inflationary expectations are increasing. Not so this time.
The inflationary expectations built into these government yields actually declined over the past nine months. The inflationary expectations built into the 5-year yield declined by 13 basis points and the inflationary expectations build into the 10-year yield declined by 14 basis points.
Fears grew about a possible recession during the summer of the year, but to actually have the inflationary expectations built into nominal yields at this time in the economic cycle is unheard of.
This means, however, that the expected real yield fell during this nine-month period. The expected real yield on the 5-year note dropped by 80 basis points, and the expected real yield on the 10-year note fell by 86 basis points.
It might be expected that the real yield would decline if a recession was expected, but economic forecasts remained relatively stable as is reflected in the projections of the Federal Reserve System. Although there is some drift downwards in the projections, basically the forecasts are in a range very similar to the growth that the economy has achieved over the past ten years.
Thus, it appears as though the decline in the nominal yields did not result from a major reduction in the economic projections for the US economy and the fall did not result from a major change in inflationary expectations. If this is correct, then what caused the decline in the US rates?
Two things, I believe, helped to account for the falling rates.
First, there has been a massive movement of risk-averse funds during the spring, summer, and into the fall. These funds have sought “safe haven” investments, and the United States has been one of the most attractive havens, as it still has “risk-free” investments that provide a positive yield.
The flow of funds has continued and has put a significant downward pressure on the interest rates in these safe havens, especially in the United States.
Second, the Federal Reserve stopped raising its policy rate of interest. In fact, the Fed lowered its policy rate twice over the summer, by 25 basis points – once in July and once in September. That impacted longer-term yields only through the expectation that there would be no further increases in the policy rate for the near future. This had a modest impact on the longer-maturity portion of the term structure of interest rates.
The bottom line of this analysis is that large flow of funds into American financial markets has helped to drive longer-term interest yields down.
Supporting this view, we find that the value of the US dollar rose quite a bit during this time period, as the flow of money into the United States had to go into US dollars first before going into the purchase of US Treasury securities.
On December 31, 2018, it took $1.1461 to buy one euro. On September 30, 2019, it took $1.0900 to buy one euro. Quite a difference! This flow of funds was not expected in late 2018.
Will this flow of funds continue at its 2019 pace? Will the flow of funds slow down? Will the flow of funds reverse themselves, resulting in pressure for longer-term US Treasury yields to rise?
I believe that it is imperative that we keep a close eye on these bond yields. Movements in these yields in the future might bear some important information that could affect other financial markets and even the economy itself.
Investors cannot afford to let this information pass them by.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.