The current low level of Treasury yields has investors concerned that the bond market is signaling a double-dip recession and the onset of deflation Significant yield changes do not go unnoticed given the bond market’s track record of signaling recessions in the past via an inverted yield curve. The bond market is coming under closer scrutiny once again given the relatively good performance from stocks over the past five weeks. The decline in the 10-year Treasury yield to a 14-month low of 2.82% and the decline in the 2-year Treasury note to a new record low of 0.50% last week has investors asking, “Is the bond market telling us something different?”
Bond Market Says No to a Double-Dip Recession
Closer inspection reveals that the bond market and near record low Treasury yields are not signaling a double-dip recession.
- The Yield Curve remains very steep by historical comparison. Perhaps the most well-known and reliable bond market indicator of future economic growth is the shape of the yield curve. A flat or inverted yield curve has preceded every recession in the United States over the past 25 years. The yield curve has also generated a few false alarms over time (twice in the mid-1990s) but its existence prior to each recession makes it an important indicator to watch. A double-dip recession is extremely rare but an inverted yield curve did precede the double-dip recession of 1981. Although the yield curve has “flattened” recently, it remains well clear of signaling a renewed recession and merely reflects slower growth expectations going forward.
- Strong corporate bond performance. The decline in Treasury yields (rise in prices) has translated into a healthy 1.0% total return for the Treasury sector since the start of the third quarter through Friday, August 6, 2010, according to Barclays index data. However, Treasuries were outshined by both investment-grade corporate bonds and high- bonds, up 2.5% and 4.0%, respectively, over the same time period, again according to Barclays index data. If the economy were slipping back into recession, economically sensitive segments of the bond market would likely underperform Treasuries like they did in both 2007 and 2008. Last week also witnessed $39 billion in new investment-grade corporate bond issuance, one of the largest weekly totals of 2010. The ability to place so much new debt during the relatively quiet summer months speaks to the health of more economically sensitive bond sectors and strongly contradicts double-dip recession fears.
And the Bond Market Says “No” to Deflation
Along with double-dip recession fears, investors have fretted over the possibility of deflation, but here too the bond market is not signaling deflation.
- Inflation rates implied by Treasury Inflation-Protected Securities (TIPS) remain positive. Since TIPS performance is partly tied to the rate of inflation, as measured by the Consumer Price Index (CPI), their yields are affected by market inflation expectations. Subtracting the yield on the 10-year TIPS from the yield on the conventional 10-year Treasury note reveals the market’s implied inflation expectation over the coming 10-years, also known as the “breakeven rate”. Both short, 2-year, and longer-term inflation expectations remain firmly positive and above a zero or negative level that would truly indicate deflation.
- TIPS have outperformed Treasuries over the past three weeks. If the bond market viewed deflation as a serious risk we would likely witness TIPS underperformance since their performance, both price and interest payments, is tied to inflation rates and a negative inflation rate (the definition of deflation) would be a deterrent to owning TIPS. On a year-to-date basis, TIPS have underperformed conventional Treasuries as overall CPI inflation has decelerated sharply from 2.7% at the end of 2009 to 1.1% through the end of June 2010. However, the recent rise in the price of oil to over $80 and firming up in home prices have sparked recent TIPS purchases. Along with a positive implied inflation rate, recent TIPS performance relative to conventional Treasuries indicates the bond market is not pricing in deflation.
So What Are Low Treasury Yields Telling Us?
The low Treasury yields ultimately reflects the two main drivers of Treasury bond performance: the Federal Reserve (Fed) and inflation. The Fed, via its ability to adjust the target Fed Funds rate, is the primary driver of short-term bond yields. With the Fed on hold for longer, given concerns over a slower pace of economic growth both domestically and in Europe, there is less risk posed to bondholders from potential rate hikes. This gives bond investors confidence to extend maturities and buy longer-term bonds helping to push intermediate yields lower in the process.
Inflation has a greater impact on intermediate and longer-term maturity Treasury yields as it is the number one enemy of longer-term bond investors. Historically, the 10-year Treasury yield has been most correlated to changes in the inflation rate. Core inflation, as measured by the CPI index less food and energy, has declined from 1.8% at the end of 2009 to 0.9% through the end of June 2010. With inflation expected to remain low over the remainder of the year, inflation risk poses less risk to bondholders over the near-term and also helped push yields lower.
Of course, lower Treasury yields do reflect a slower pace of economic growth as well since bond market expectations of future Fed actions and future inflation ultimately derive in large part from the pace of economic growth. However, it is important to distinguish between a slower pace of economic growth and a recession and/or deflation. The bond market has so far signaled “no” to both a double-dip recession and deflation.
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
- Consumer Price index (CPI) is a measure estimating the average price of consumer goods and services purchased by households.
- Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index – while providing a real rate of return guaranteed by the U.S. Government.
- The market value of Corporate Bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.