Falling U.S. Bond Yields: The Market Surprise for 2014

June 3rd, 2014 | By Nick Sargen

Note: Fort Washington Investment Advisors, Inc. (Fort Washington) is pleased to announce the appointment of Steven K. Kreider as its new Chief Investment Officer, succeeding Nicholas P. Sargen in the role effective May 30, 2014. After a long and successful tenure as Chief Investment Officer, Mr. Sargen will remain with Fort Washington and continue to serve the company as Chief Economist and Senior Investment Advisor. In his role as Chief Economist Nick will continue to update his blog with current market and economic information.


  • Last week's decline in Treasury yields took the 10 year yield close to 2.4%, the lowest level in a year. The move primarily reflects technical factors, as well as ongoing concerns about global weakness, especially in Europe.
  • The cumulative 60 basis point decline in bond yields this year also reflects revised expectations about U.S. monetary policy. Previously, market participants expected the federal funds rate to rise to 4.5% over the next five years; now they are pricing in the funds rate to peak at 3.5%.
  • We expect bond yields will move higher in the balance of this year as the U.S. economy regains momentum. Accordingly, we are maintaining an underweight duration position in fixed income portfolios.

What's Behind the Decline in Yields?

Until the past few weeks, Treasury yields had fluctuated in trading ranges, with the 10 year yield centered about 2.7%. During May, the market broke out of its range, as yields fell by 25-30 basis points. The decline sent the 10 year Treasury yield near 2.4%, the level where it was a year ago. This has surprised many investors, including ourselves, considering that recent economic data suggest the U.S. economy is recovering from its first quarter slump and the Federal Reserve is continuing to scale back its bond purchase program.

Commentators have offered several explanations for the drop in yields. One is that growth abroad continues to disappoint, with the euro-zone being the latest example: Real GDP growth for the region was barely positive in the first quarter, despite a strong showing for Germany. With inflation in the euro-zone averaging less than 1%, market participants anticipate the European Central Bank will ease monetary policy this week, possibly by initiating a bond purchase program or by effectively taxing banks on their holdings of excess reserves. Amid these developments, bond yields for Germany, France and other core countries are below those of U.S. Treasuries, while 10-year yields for Spain and Italy have fallen to about 3%. Therefore, global investors may find Treasuries attractive by comparison.

Another explanation is that investors are revising the long-term prospects for the U.S. economy lower such that potential growth may be closer to 2% than 3%. If so, they reason that real – or inflation adjusted – bond yields may be lower than the historic average of 2.5%-3%. In this regard, investors at the same time have lowered their expectations of where the federal funds rate will be five years from now by a considerable amount: The bond market currently is pricing the federal funds rate to reach 3.5% in 2019, as compared with 4.5% at the beginning of this year.

While there is some validity to these arguments, our assessment is that most of the recent decline in yields is due to technical factors. Investors began 2014 optimistic that the U.S. economy would grow by 3% or more for the first time since the 2008 financial crisis. They were initially able to look past first quarter weakness on grounds it was weather related. However, amid indications the global economy is still soft, investors who were positioned for a rise in interest rates may be closing out their short duration positions.

Not Ready to Throw in the Towel Yet

Considering how far yields have declined this year, some clients may be wondering whether we still expect the 10 year yield will rise in the balance of this year. My answer is that this is the most likely outcome for the following reasons:

  • The U.S. economy is regaining momentum. It is not as weak as Q1 GDP suggests, as the downward revision to the first quarter mainly reflectedlower inventory accumulation, which is likely to be temporary. Key indicators including monthly jobs growth, weekly jobless claims, and purchasing manager surveys point to a rebound in the current quarter. We are awaiting data for May to provide additional confirmation that the economy is on track for 3% growth.
  • Inflation has bottomed. The bond market has been bolstered by unusually low inflation, with the closely watched core PCE index rising by only 1.1%-1.2% year-over-year, well below the Fed's threshold range of 2%-2.5%. However, there are signs that inflation is about to drift higher: Last year's 2% cut to Medicare reimbursement rates will not affect future readings, and prices for consumer goods and services and rental costs are showing signs of upward pressure.
  • The Fed is on track to wind down quantitative easing by autumn. Fed officials remain confident that the economy is on solid footing, although some have expressed concerns about softness in the housing market. They are committed to scaling back the bond purchase program, and in a recent speech, NY Fed President William Dudley indicated the Fed could start raising interest rates next year without shrinking its balance sheet.
  • Market volatility is unusually low. Implied volatilities for the stock market and currency market are the lowest since before the financial crisis. Bond market volatility is also low, partly due to the role central banks have played through quantitative easing, as well as the diminished role of proprietary trading among commercial banks. Nonetheless, market conditions can change very quickly, as occurred one year ago when the Fed announced it was contemplating tapering its bond purchase program.

Based on these considerations, we believe bond yields will rise as the U.S. economy gains traction. However, we also recognize that conditions abroad are weaker than expected, and international forces could limit the increase in U.S. yields. Our plan is to update the outlook for the second half of this year once we have a read on how the U.S. and global economy fared in May. Meanwhile, we are maintaining an underweight duration position in fixed income portfolios.