4th October 2010
Just how low the yields are, is made clear when it is considered that, apart from a two-month period during the 2008 financial crisis, they have not fallen to such levels since the Great Depression.
The decline has defied expectations and has led to many investors and market commentators suggesting that such low yields are the result of speculation and cannot be sustained, in effect arguing that a bond bubble is being created.
High demand and low yields for treasury notes mean low interest rates, theoretically creating an environment for affordable mortgages and helping to stimulate the economy. And there is no doubt that US interest rates are currently very low, effectively zero percent.
This rate policy by the Federal Reserve is the loosest it has been for the last 30 years and the big worry is that it is creating so much liquidity that inflation is sure to occur. That would eventually erode the principal value of the longer maturity bonds.
David Harris, Senior Fixed Income Portfolio Manager at Schroder, says the Fed's loose monetary policy, aims to fight the risk of a debilitating, Japan-like deflation through printing enough dollars to spark inflation, thereby generating higher inflation, which the Fed knows how to fight, rather than risk outright price declines where deflation-fighting policies, again from the WSJ, are uncertain.
He adds: "The Federal Reserve has never confronted deflation in the modern financial era, and this marks a massive shift in direction from the Fed's main concern over the last three decades. Bonds have benefited from the Fed's inflation-fighting credentials, established since 1980, so its efforts to create inflation are understandably scaring bond investors."
So under these circumstance, does the rush into treasuries indicate a bond bubble is brewing? Harris believes not, arguing that while Fed policy will be inflationary, eventually, the most important issue is where that inflation occurs.
"Consumer prices do not capture the full impact of easy monetary policy. Inflation may be beginning in an unexpected part of the economy, and we think we know where it is…"
Intriguingly, the answer for Harris lies within demographics, more specifically the post-World War II baby boom generation. He explains that when money is cheap, like it is now, inflation will occur: "It is just a matter of time – usually with significant lags – as well as a matter of where, what goods are pursued with the cheap money."
He adds: "Inflation can take many different forms and will appear predominantly in the economic sector that is in demand the most. In the last four decades, the ‘in demand' sector has been determined by demographics – the baby boom."
Using the real Fed funds rate (Fed funds rate minus core inflation) as a simple measure of monetary conditions, Harris has carried out some research which indicates that there have been four periods of very easy money since 1970.
In each case price rises were experienced in sectors relating to spending by the Boomer generation, culminating in the latest in bonds, which began in early 2010 and saw demand from average Boomer aged 55-58.
"These connections make sense," says Harris. "In each case the Boomer generation's collective buying power overwhelmed existing supply.
"Now, as the Boomer generation approaches retirement, investment preferences are shifting to income and stability – especially after the volatility of the dot.com and housing bubbles – and the bond market is benefiting, even as total Treasury supply also accelerates."
Harris concedes that the chasing of higher bond prices may eventually turn speculative and lead to a bubble in bonds. And there will surely come a time when the US economy is growing more rapidly and wage pressures begin to mount.
However, he believes these factors, alongside weak economic trends and deflationary impact of debt reduction, are a long way from being a threat to low interest rates.
"In that context, record low bond yields make plenty of sense," he says.
Harris' full analysis can be viewed here.