(Bloomberg) — Stubbornly low Treasury yields are spurring Wall Street to slash forecasts for the months ahead, and whether the Federal Reserve winds up raising rates again has little to do with it.
At about 2.25%, 10-year yields are plumbing 2017 lows, following a rally Wednesday as the central bank signaled an imminent rate hike but also a gradual approach to shrinking its massive bond portfolio. Banks including Goldman Sachs Group Inc. and JPMorgan Chase & Co. cut year-end yield forecasts this month, while maintaining calls for more tightening. The underlying message: While the economy may be robust enough to warrant further Fed moves, the bond-market forces that drove yields to record lows last year are still intact.
The story isn’t playing out as expected this year, as investors and analysts navigate a slew of forces beyond just the path of short-term rates — faltering inflation data, waning confidence in Donald Trump’s agenda, haven demand and a growing conviction that the bond market will smoothly digest the transition to a smaller Fed balance sheet.
“Our expectation is the Treasury market is priced appropriately for muted inflation and muted growth for the rest of the year,” said Rich Piccirillo, a portfolio manager at Prudential Financial Inc.’s fixed-income business, PGIM Fixed Income, which oversees $654 billion. Yet “you’re going to need more disappointing data than just a couple weak inflation CPI prints to move them off of hiking in June. The FOMC’s desire is to normalize policy.”
Here’s what’s depressing yields even with the Fed seemingly bent on tightening.
The so-called Trump trade that drove financial markets for months is close to dead as gridlock grips Washington.
The 10-year breakeven rate, which gauges market expectations for inflation over the next decade, is close to the lowest since November. That’s a sure sign that bond-market bets on faster growth and inflation — inspired by the prospect of tax cuts, deregulation and infrastructure spending at a time when unemployment was already plunging — have mostly run their course.
“The new reality is the growth forecasts are probably a little bit tamer than they were at the beginning of the year,” said Gemma Wright-Casparius, a senior money manager at Vanguard Group Inc., which oversees about $4 trillion. “That markdown and the inflation reassessment story is what is really starting to push down the yield forecasts.”
Haven on Earth
Lately, the decline in yields has also reflected day-to-day revelations about the Trump campaign’s ties to Russia. After a memo written by former FBI director James Comey surfaced last week alleging that the president asked him to drop an investigation of former National Security Adviser Michael Flynn, Treasuries rallied the most since July, Bloomberg Barclays index data show.
“You have a bit of a crisis of confidence over Trump getting through a lot of the deregulation, the fiscal stimulus and tax reform — which has now been pushed to the back burner as a result of the headwinds with Russia and the FBI,” said Nick Maroutsos, portfolio manager at Janus Capital Group, which oversees about $200 billion. “The natural buying from offshore will put a cap on yields.”
Financial conditions have actually eased since the Fed lifted rates in March, helping limit upward pressure on yields. Goldman Sachs economists say the looser conditions are a reason for the Fed to do more, and they expect policy makers to boost rates by a quarter-point three to four times annually through 2019.
For many investors and analysts, the drop in yields this year comes back to the forces that have sustained the three-decade bond bull market time and again. With the Bank of Japan and European Central Bank still buying debt, U.S. yields are among the highest worldwide.
Couple that with an aging global population that craves fixed income, plus sovereign governments running up budget deficits, and it’s little surprise that growth — and, by extension, bond yields — have muddled along at such low levels.
“There’s a difference between good growth and good enough growth for the Fed to move,” said Joel Naroff, president of Naroff Economic Advisors. “I’m not backing off that the Fed is going to continue, yet I don’t necessarily think that rates are going to rise as much now as I thought going into the year.”
He cut his forecast in May for 10-year yields, to 2.8% at year-end from 3.2%.
And then there’s the matter of the Fed’s $4.5 trillion balance sheet, amassed amid efforts to support the economy.
The gap between two-and 10-year yields narrowed after Wednesday’s release of minutes from the Fed’s latest meeting, which shed some light on plans to unwind the stash of debt.
The takeaway for investors: Officials discussed a system of rolling caps that will keep the drawdown gradual. The aim, according to the minutes, is to mitigate the fallout in financial markets and avoid roiling long-term rates.
“This portfolio unwind will very much be a slow, gradual and most importantly a methodical process,” wrote Walter Schmidt, senior vice president of structured products at FTN Financial.
— Read Low Yields Squeeze Annuity Renewal Rates on ThinkAdvisor.