When it comes to predicting where U.S. borrowing costs are headed, the bond market isn’t taking Wall Street’s advice seriously.
After giving up on calls last month that Treasury yields will rise in 2014, forecasters are sticking to estimates those on the 10-year note will climb next year and reach 3.6 percent as the Federal Reserve increases interest rates. Yet based on the performance of long-term Treasuries, implied yields suggest investors don’t foresee yields that high for a decade or more.
Getting it right has never been more important. With America’s outstanding public debt at a record $17.7 trillion, Fed Chair Janet Yellen faces the task of lifting rates from close to zero without sparking a surge in funding costs. While economists point to unrest in Ukraine and Gaza for why Treasuries remain in demand, the bond market’s view that the U.S. expansion isn’t strong enough to force the Fed’s hand suggests yields can stay low for years to come.
“The market indicators are telling us that forecasts are too aggressive,” Michael Darda, the chief economist at MKM Partners LLC, said in a telephone interview from Stamford, Connecticut, on Aug. 18. That helps to show “the ankle biting about the Fed being behind the curve is nonsensical.”
As the Fed’s focus shifts from bond buying to raising rates, more financial professionals are concerned the central bank isn’t moving fast enough. Fifty-one percent of those surveyed said that U.S. monetary policy is too accommodative, a Bloomberg Global Poll showed last month.
Fed officials have started to recalibrate their own views on how long the overnight target rate needs to stay between zero and 0.25 percent as the U.S. recovery enters its sixth year, even as Yellen emphasized last week that slack in the labor markets remains “significant” at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming.
Minutes of the bank’s July policy meeting released on Aug. 20 showed “many” participants said the Fed might raise borrowing costs sooner than they had anticipated.
Even if they do, investors in the $12.2 trillion market for Treasuries harbor few of the worries that would lead to the jump in yields that economists and strategists anticipate.
The differences between yields on Treasuries of different maturities imply the benchmark 10-year note, which has fallen more than a half-percentage point this year to 2.4 percent today, will only reach 2.8 percent by the end of 2015, according to data compiled by Bloomberg.
That’s 0.8 percentage point lower than the median estimate of 3.6 percent from 58 forecasters surveyed by Bloomberg. In fact, implied yields show the 10-year note may remain below that projection beyond 2024.
The divergence reflects investors’ deepening conviction that a lack of sustained wage growth and any resulting inflation will hold back the economy, which has been weaker on average than the past three expansions. That means the Fed won’t need to raise rates as much as it has in the past.
Average hourly earnings were unchanged in July, the third time in five months that they rose less than economists’ estimates. On an annual basis, the current growth in wages has been the slower over the course of any expansion since at least the 1960s, data compiled by Bloomberg show.
Meanwhile, consumer prices using the Fed’s preferred gauge have risen less than its 2 percent target for 26 months.
“Yields are consistent with a new normal economy where we will have much lower peaks during interest-rate cycles and lower inflation,” Robin Marshall, London-based director of fixed income at Smith & Williamson Investment Management, which oversees $25 billion, said by telephone on Aug. 22.
Peak rates, known as the neutral or terminal rate, have averaged 4.25 percent when inflation has historically been at the bank’s current target, New York Fed President William Dudley said in May. Trading in the interest-rate swaps suggests benchmark borrowing costs will top out closer to 3 percent.
Swaps based on the Fed funds effective rate, a proxy for the target rate, indicate it will average 2.84 percent in 2019. Another gauge, the one-year swap traded five years forward, has fallen a full percentage point this year to 3.2 percent.
Those peak levels are lower than the Fed’s own “dot plot” projections released in June, which showed a long-term forecast of 3.75 percent based on the median estimate. If the bond-market indicators prove to be accurate, they would also be the lowest since the 1950s, according to MKM’s Darda.
“If the potential growth rate of the U.S. economy is falling then the neutral policy rate will prove to be lower than in the past,” Dana Saporta, New York-based director of U.S. economic research at Credit Suisse Group AG, said Aug. 19.
To Priya Misra, New York-based head of U.S. rates strategy at Bank of America Corp. (BAC), the bond market has become too downbeat on the economy’s ability to generate demand.
Employers have added more than 200,000 jobs for six straight months, the most since 1997. That will fuel growth next year that’s faster than the median economist estimate of 3 percent -- which would be the strongest in a decade, she said.
“People are extrapolating from the last few years, that if you can’t grow during the first few years after a recession with a recovery with significant stimulus, then we’ll never be able to grow,” said by telephone Aug. 21. “That misses the point.”
The bank, one of 22 dealers that trade directly with the Fed, predicts the economy will expand 3.2 percent in 2015 and lift 10-year yields to 3.75 percent by the end of that year. Both forecasts are among the highest in Bloomberg surveys.
With yields so low, investors may also be too complacent that the Fed can extricate itself from the most-aggressive stimulus in its 100-year history without any disruptions, said Barry HoAire, money manager at Los Angeles-based Bel Air Investment Advisors LLC, which oversees $7 billion.
“The market is priced for perfection,” he said Aug. 22. “It is saying that everything the Fed is telling us will happen will happen. I don’t know if I necessarily buy that.”
Anticipating a selloff in Treasuries has proven to be futile this year. In January, strategists and economists said 10-year yields would rise to 3.44 percent by year-end.
Since then, they’ve had to chop their projections every month as everything from the harsh winter to geopolitical turmoil and lackluster wage growth prompted investors to pour into Treasuries. Last month, they abandoned calls for yields in 2014 to rise from 3.03 percent at the end of last year.
Any jump in yields will be tempered by anticipation the European Central Bank will start its own quantitative easing, according to Zach Pandl, the Minneapolis-based senior interest-rate strategist at Columbia Management Investment Advisers, which oversees $340 billion.
Germany’s economy shrank more in the second quarter than analysts projected while France’s stagnated, adding pressure on the ECB to take more aggressive action. On June 5, it became the first major central bank to take one of its main rates negative.
“The elephant in the room” is Europe, Pandl said. The likelihood of quantitative easing by the ECB helps explain “the low level of long-term rates in the U.S.”