In January, wrote in this column, “I will be watching the bond market for my queues on the stock market during 2014."
My expectation when I wrote this was for interest rates to rise throughout the year as the Federal Reserve continued to reduce its bond buying quantitative easing (QE) program.
As a quick refresher, interest rates are determined in primarily two different ways. Short-term interest rates are largely influenced the Federal Reserve which, through a variety of policies, establishes the rates used by banks for deposits and lending.
Longer-term interest rates however, are determined in the bond market. When bond prices go down, interest rates go up and vice versa. Longer-term rates are also being influenced by the Federal Reserve through its QE program, which the Fed has been scaling back this year.
Logic implies as the Fed continued to reduce its bond buying QE program, bond prices would likely go down causing interest rates to rise. For many of us investment geeks it wasn’t considered a matter of “if” this would happen, but only a question of how quickly it would occur.
Instead the exact opposite is now occurring. Bond prices, primarily U.S. Treasury bonds, are actually going up causing interest rates, or yields, to go down. This is puzzling and has me scratching my head.
This trend could be viewed as a negative predictor for the economy and the stock market. U.S. Treasury bonds are considered among the world’s safest investments. Investors clamoring into Treasuries could be a sign the appetite for risk (i.e. stocks) is going down, which typically means investors are becoming concerned about recession or slowing economic growth.
Longer-term interest rates also reflect how investors feel about inflation. Five years into our economic recovery we still haven’t experienced material inflation (according to the government's measuring stick), and lower rates could indicate concern about the trend of deflation, or prices going down over time. A deflationary environment is also bad for stocks and for our economy, so on the surface this increased demand for U.S. Treasuries could be viewed as a foreboding sign of things to come.
If this were the case, however, we would expect to see some storm clouds in the stock market as well, but besides a little increased volatility in the past two weeks this simply hasn’t yet been the case.
This sends me looking for another explanation. U.S. Treasuries are one of the world’s safest investments, but not the only safe option. German Bunds, and Japanese Government Bonds have also historically served as safe harbor investments. A look at these 10-year bonds shows German bonds paying 1.42 percent and Japanese Bonds paying .58 percent. These yields make the 10-year U.S. Treasury at 2.5 percent look like a no-brainer.
So instead of declining yields on U.S. Treasuries being a reflection of trouble, maybe this just represent an old fashion “better deal” for safe investors. Either way, this trend is definitely worth watching.