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posted on 17 September 2016

Whither Bond Yields?

by Gene D. Balas

One way to think of financial markets might be as a Ouija board, with millions of investors pushing and pulling on asset prices in response to an infinite number of data points. Given that metaphor, it's perhaps no wonder that I generally don't like making very specific forecasts. But one might look at aspects of the markets and economy to assess whether some imbalances, or even risks, might exist.


The role of central banks - and the eventual limitations of monetary stimulus

Right now, some of those imbalances may have been created by central banks, not just the Federal Reserve in the U.S., but also the European Central Bank (ECB), the Bank of Japan (BoJ), and others. The ECB has been buying bonds to drive down interest rates, in some cases into negative territory, along with maintaining a negative policy rate. That is also the case with the BoJ.

However, there are limits to this strategy. Not only that negative rates might not make conceptual sense - but they can be counterproductive, too, in that savers need to save even more to reach their goals. Negative rates may not motivate them borrow and spend more. Thus, these programs may be arguably of limited use, and aren't popular among the many people who depend on their savings for income. With that as a backdrop, the ECB disappointed investors by not discussing extending its bond-buying program when it met on September 8. And in related news, it has been widely reported that the BoJ may even run out of qualifying bonds to buy.

Why does it matter what happens to yields abroad?

The end result is that yields in Europe and Japan have been inching back up. The yield on the 10-year German bund, which had been as low as negative 20 basis points in the past twelve months, is now a positive 8 basis points as of September 13. The Japanese 10-year note is similarly edging higher.

What does that mean for U.S. investors, who might not even consider investing in fixed income abroad? Plenty, as it turns out, as yields in Europe and Japan have dragged U.S. yields lower, as investors globally have favored U.S. bonds instead of European or Japanese counterparts to invest their funds. Consider the relationship between German and U.S. 10-year bond yields in the nearby graph.


Is the flattening yield curve a valid signal - or is it an unsustainable imbalance?

German yields are an anchor on Treasury yields, so any tick upwards there can matter here, too. But that's not the only consideration. Take, for example, the spread between the 10-year U.S. Treasury and the 2-year U.S. Treasury. This basically represents how steep (or flat) the yield curve is. Generally speaking, the difference tends to be greater (i.e., a steeper yield curve) when interest rates, growth and inflation are expected to increase, and smaller (or even negative) when, for example, investors might think the economy might head into a recession, or at least exhibit significantly slowing growth.


As seen in the nearby graph, that gap has been narrowing considerably in recent years. So, is it because the market thinks we are headed into recession? To answer that question, consider the Philadelphia Fed's Survey of Professional Forecasters. The panel expects real GDP to grow at an annual rate of 2.6% this quarter and 2.3% next quarter. Moreover, they predict real GDP will grow 2.3% in 2017, 2.2% in 2018, and 2.2% in 2019. That's an improvement over their full-year forecast of 2016 growth to be 1.5%, so the narrowing gap between the 2-year and 10-year Treasury spread (a flattening yield curve) isn't likely a case of investors expecting a recession.


Instead, as I noted earlier, part of the influence is due to central bank actions abroad. With the ECB signaling that it didn't discuss extending its bond-buying program, we may assume that eventually, that anchor from lower yields abroad may fail to suppress U.S. government bond yields. And that imbalance evident in the narrow spreads between the 2-year and 10-year Treasury may potentially see longer-dated yields gap higher, though if and when that may occur is debatable.

Indeed, as I noted at the beginning of the article, making specific forecasts is fraught with risks, given the unpredictable nature of millions of investors and the array of data they follow. But identifying potential risks is often a worthwhile endeavor - even if nobody can guarantee the actual outcome.


Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.

The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.

© 2016 United Capital Financial Advisers, LLC. All Rights Reserved

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