Is This A New Era For Yields?
For financial market participants, it is often important to take a step back and
determine what long-term economic trends, if any, are in place and how are they
affecting the markets.
Ever since the late 70’s, when inflation was having a debilitating effect on the
US economy, one of the Fed’s primary objectives has been to keep inflation in
check by aggressively raising short-term interest rates whenever the economy has
shown signs of overheating–since economic growth and inflation go hand in hand.
And since the early 1980s, inflation has been gradually declining thanks in
part to the Fed. At the same time, bond prices have been in a long-term
up-trend, pushing yields–which are inversely related to price–to levels not
seen since the 1940s. As you know, inflation affects the value of fixed income
instruments. The reason is that during periods of rising inflation, the
purchasing power of a bond’s payments decreases, pushing the price of the
instrument lower as a result. Conversely, during periods of falling inflation,
the purchasing power associated with a bond’s payout increases, making the bond
a more attractive investment. The chart below illustrates the effect that
falling inflation has had on the 10 year Treasury yields for the past 20 years.
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We are now entering a new era however.
At its meeting last May, the Fed changed its directive to target inflation and
economic growth separately. The reason behind this change in posture is that
inflation is hitting levels not seen since the 1960s and any further sustained
decline could trigger a deflationary spiral to take hold of the economy. It
is reasonable to assume, however, that just as the Fed succeeded at stomping out
inflation, so too will it succeed at inflating the price of goods.
In my view, a meaningful rise in inflation will not likely occur until some of the
remaining slack in the economy is tightened–that is, low capacity utilization. The
bond market has accepted this notion, which in
turn, has helped ease the selling pressure on bonds that began last July.
Nevertheless, investors should expect a gradual reversal in what has been a three-decade-long run in the bond market.