June 3rd, 2014 | By Nick SargenNote: 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.
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.
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:
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.