The Bond Market Is Raising a Cautionary FlagLearn more about this firm
- The yield on the benchmark 10-year Treasury note won't rise much above 2.5% in 2016.
- Fed tightening cycles typically see curves flatten but long rates also typically rise, pricing in faster growth and inflation.
- The lack of conviction from the bond market that this will be the case represents an important cautionary flag.
In early December, I usually provide my views on the range of the 10-year Treasury yield for the coming year. I do this weighing all the factors I believe will influence interest rates such a growth, inflation, liquidity, supply, demand, etc. In late 2014 I expected that the 10-year yield would see a low of 1.75% and a high of 2.75% at some time during 2015. The low point I was very close, with the 10-year yield, brushing 1.65% in late January. However, the high point that I forecast missed the mark. My estimate was actually too high, and yields never ascended above 2.5%.
It is with much consternation that I have reduced my forecast range for 10-year Treasury yields yet again. Some may be surprised at this, with the Fed beginning a tightening cycle and hiking rates for the first time in almost ten years. But that is actually one of the factors that lead me in that direction. For the most part, I expect that the 10-year Treasury will see a range of 1.5% on the low end and 2.5% on the high end.
To some degree, much depends on whether you believe yields remain in their bullish (lower) long-term trend as they have over the last 35 years. I expect that trend will remain in place unless violated, and so far those long-term trends are not impaired. Yields need to remain in sync with growth and inflation, and both I believe are lower for longer.
The Fed begins this tightening cycle seeking to exit a zero interest rate policy that no other developed economy has successfully exited or negotiated. Other central banks have all had to reverse course once data did not cooperate with their rosy views. This Fed begins the cycle missing on the inflation target (and not by a small amount), barely hitting their growth target, with inflation expectations very muted, commodity prices still tanking (including gold), and high-yield spreads moaning loudly. They remain ever faithful in their belief in the Phillips Curve and its relationship to wage pressures—even if that relationship has been weak. While the Fed says they will move gingerly, this is an experiment and the risk of error is great. Some believe that this Fed tightening cycle already began when QE ended and the Fed’s balance sheet leveled out. This would be consistent with the tighter financial conditions witnessed mid-2015, which have only slightly eased. Another factor that may keep a lid on yields is that Treasury note and bond issuance is estimated to fall by 27% in 2016, while the global appetite for treasuries remains brisk.
Bond markets too seem to be signaling some skepticism about the outlook for rates. The 2-year/10-year Treasury yield curve 5-years forward dropped back into negative territory once the Fed reaffirmed its intentions in October. This signals that markets believe the rise in policy rates that is being priced in now will serve to further flatten the curve. Fed tightening cycles typically see curves flatten but long rates also typically rise, pricing in faster growth and inflation. The lack of conviction from the bond market that this will be the case represents an important cautionary flag.