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 that 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. You could say the same about inflation: a sharp fall in 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 that the US Treasury was tapering its borrowing even faster.
Investors probably also underestimated the continued demand for bonds coming from pension funds re-balancing 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. That suggests that 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% before the financial crisis. But futures contracts are currently pricing in a 10-year real rate below 1% for the next three years, and not going over 1.5% at any point in the next decade.
That is possible. But I do not 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. 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 be a shock to anyone if they start to creep up soon.
