At the start of 2014, most professional investors, including City National Rochdale, were forecasting that the U.S. economy would finally jettison the sluggish activity pattern that characterized the prior four years in favor of a faster growth trajectory.
Coupled with the Federal Reserve's stated intention to begin tapering its bond buying activities, it seemed like a good bet that the combination of higher growth and less demand from the Fed would send interest rates modestly higher over the course of the year. We forecasted that the yield on the 10 year U.S. Treasury note would increase from 3.0% to anywhere between 3.3% and 3.8% by year end. However, the bond market has a way of confounding even the most rational of forecasts. Last week the 10 year Treasury (considered the bellwether for the bond market) yielded 2.5%, providing a year-to-date total return of more than 12.0% to investors willing to own long-term U.S. government bonds – far outpacing the returns of every other major asset class. Beyond the surprising fall in interest rates, is the bond market telling us the economy is on shaky ground?
Bond yields usually fall when economic activity is expected to decline, so one possible explanation is that bond investors foresee an economic picture that is darkening rather than brightening. There is no doubt that the first quarter's U.S. real GDP growth rate of 0.1%, even after accounting for the frigid winter weather, was well below economist projections. Yet, the trend of economic data has been significantly better since then (including a noticeable pickup in job growth), and most forecasters believe second quarter GDP could be 3.5% or higher. We continue to believe the odds of a significant slowdown in U.S. economic growth in the next twelve months are quite low.
If it is not the economy, what else could be driving interest rates down to a level last seen in October 2013? One oft-cited explanation is a flight-to-quality caused by the ongoing tensions between Russia and Ukraine. Another is the sharp decline in European bond yields (where the economy truly is struggling) that improves the relative attractiveness of U.S. government debt. Perhaps bond investors expect inflation to fall despite a pickup in growth, but the recent inflation data is pointing to modestly higher, not lower inflation. Some strategists have noted the automatic rebalancing of large pension funds out of stocks into bonds after last year’s sharp rally in stocks, contributing to increased demand for bonds. One less publicized factor is the Treasury’s diminished appetite for issuing new debt, owing to the steady improvement in the federal deficit over the last several years. It is likely that each of these factors has played a role in the sharp drop in yields so far this year.
At least two important lessons should be gleaned from this experience. One is that interest rates are just as difficult to forecast in the short run as the stock market. The second is that bond portfolios can provide attractive total returns, even when starting rates are low, if interest rates are falling. For these reasons, we believe bonds should represent a meaningful position in the diversified portfolios of most investors.
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