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Financial Industry Insights from Advisors Asset Management
On September 08, 2014
Viewpoints from AAM - Why Are Treasury Yields Going Down?
It’s difficult to predict where interest rates are headed. We finished 2013 with 10-year Treasury yields near 3% and the majority of bond managers expected rates to continue to rise during 2014. However, by August 28, 2014 the 10-year Treasury declined 22.8% to a yield of 2.33%, a 13-month low. This movement in rates and the continued expectations that rates will rise – eventually – has many investors sitting on the fence and missing potential opportunities in the market. The S&P 500 total return this year is 9.6% (as of 9/4/14), the Barclays Aggregate Index has returned 4.37% YTD and the Barclays Municipal Index has returned 7.19% this year.
There are many factors that contribute to the volatility in Treasury yields; a few of them are highlighted below:
Demographic Changes
Don’t underestimate the importance of changing demographics as current estimates show the number of Americans over 65 years old will grow by 14.5 million this decade. As Baby Boomers continue to age, we expect to see demand for Treasuries increase as older Americans look for steady income with little risk. More individuals entering retirement also means the workforce is shrinking, which leads to less spending and potentially lower inflation. These factors can contribute to lower interest rates as inflation is positively correlated to interest rates. Let’s also not forget the impact on wage growth when losing millions of people at peak income levels and replacing them with younger individuals that are early in their careers.
Geopolitical Concerns
Geopolitical turmoil tends to create a flight to quality and there are many ongoing issues across the globe right now, but Ukraine seems to be the biggest headline this week. Following a meeting between Ukrainian President Petro Poroshenko and Russian President Vladimir Putin, the Ukrainian presidential press office stated that a "mutual understanding was achieved” regarding the possibility of a “permanent ceasefire” in the eastern region of Ukraine. This news created a big intraday swing in Treasury yields.
Eurozone Sovereign Yields
As illustrated below, yields in the Eurozone have plunged as Europe continues to face recessionary and deflationary pressures. By comparison, U.S. Treasury yields look attractive. Foreign sovereigns and central banks are increasing demand in U.S. Treasuries.
Source: St. Louis Federal Reserve
Federal Reserve Policy
The Fed has been committed to keeping rates low with loose monetary policy since the 2008 financial crisis. The Fed has kept the fed funds rate near zero since December 2008 in an effort to boost economic growth and create jobs. The Fed also initiated three rounds of quantitative easing (QE) which boosted the balance sheet over $4 trillion. In QE1 the Fed purchased approximately $1.75 trillion in mortgage-backed securities and Treasuries. The second round (QE2) consisted of an additional purchases of $600 billion in long-term Treasuries, and QE3 was designed to purchase $40 billion worth of mortgage-backed securities each month. Even with the Fed paring its purchases this year, the U.S. Treasury market has continued to rally. The Fed will continue to pursue a monetary policy that would help achieve its goals of price stability and employment at optimal levels.
Economic Data
Employment
Housing Starts/Permits
Leading Economic Indicators
In January 2014, the majority of bond managers and economists were continuing to call for higher rates by year-end with 10-year U.S. Treasury yield estimates near 3.4%. However, in July the survey median was 3% and the August survey median was down to 2.92%. The median for 2015 year-end is currently at 3.6%. We are not forecasting a sharp rise in rates, but our longer term view is for higher rates with the potential for even lower rates in the short term. It’s difficult to predict interest rates as there are so many factors that contribute to the direction of yields. The 10-year U.S. Treasury is used as a barometer for interest rates and the factors shown above are only a few of the many variables that can impact rates. In my opinion, the important decision is not whether you should be invested, but what investments could help you meet your goals and stay within your risk tolerance. The current low interest rate environment is providing little return for the extreme amount of duration risk investors are taking to find more income. In addition to standard fixed income investments, we continue to look for opportunities in income investments such as Business Development Companies (BDCs), Real Estate Investment Trusts (REITS), Master Limited Partnerships (MLPs), and Emerging Markets. Investors should consider asset classes (and/or sectors) that may have fallen out of favor and we continue to find value in base metals, basic materials and miners.
The chart below shows the yield curve has been flattening, but remains positively pitched. Remember, the fixed income market is forward looking and this trend indicates a potential slowdown in the economy. If we get confirmation from the data, we should reduce credit exposure. The spread between the 30-year Treasury yields and the 5-year Treasury yields dropped to 142 basis points (bps) intraday on August 28 and has since rebounded to 153 bps. We have not witnessed the yield curve this flat since early January 2009. Remember to look for confirmation in the economic data before making adjustments to your allocation as you see the risk begin to outweigh the reward.
CRN: 2014-0905-4395R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com
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