Misperceptions Create Significant Bond Market Value
From the cyclical monthly high in interest rates in the 1990-91 recession through June of this year, the 30-year Treasury bond yield has dropped from 9% to 3%. This massive decline in long rates was hardly smooth with nine significant backups. In these nine cases yields rose an average of 127 basis points, with the range from about 200 basis points to 60 basis points (Chart 1). The recent move from the monthly low in February has been modest by comparison. Importantly, this powerful 6 percentage point downward move in long-term Treasury rates was nearly identical to the decline in the rate of inflation as measured by the monthly year-over-year change in the Consumer Price Index which moved from just over 6% in 1990 to 0% today. Therefore, it was the backdrop of shifting inflationary circumstances that once again determined the trend in long-term Treasury bond yields.
In almost all cases, including the most recent rise, the intermittent change in psychology that drove interest rates higher in the short run, occurred despite weakening inflation. There was, however, always a strong sentiment that the rise marked the end of the bull market, and a major trend reversal was taking place. This is also the case today.
Presently, four misperceptions have pushed Treasury bond yields to levels that represent significant value for long-term investors. These are:
1. The recent downturn in economic activity will give way to improving conditions and even higher bond yields.
2. Intensifying cost pressures will lead to higher inflation/yields.
3. The inevitable normalization of the Federal Funds rate will work its way up along the yield curve causing long rates to rise.
4. The bond market is in a bubble, and like all manias, it will eventually burst.
Rebounding Economy and Higher Yields
The most widely held view of these four misperceptions is that the poor performance of the U.S. economy thus far in 2015 is due to transitory factors. As those conditions fade, the economy will strengthen, sparking inflation and causing bond yields to move even higher. The premise is not compelling, as there is solid evidence of a persistent shift towards lower growth. Industrial output is expected to decline more in the second quarter than the first. This will be the only back-to-back decrease in industrial production since the recession ended in 2009 (Chart 2). Any significant economic acceleration is doubtful without participation from the economy’s highest value-added sector. To be sure, the economy recorded higher growth in the second quarter, but that was an easy comparison after nominal and real GDP both contracted in the first quarter.
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