It was hard to miss the headlines earlier this week about the 10-year Treasury yield dipping below 2% Wednesday, hitting its lowest level in over a year.
And though the 10-year yield recovered somewhat Thursday as Treasury prices dropped, Wednesday’s dip below 2% came as a surprise. Many investors, me included, had been expecting a more consistently slow and steady rise in yields, as the U.S. economy continues to recover and the Federal Reserve (Fed)’s rate normalization nears.
So what caused the sharp drop? A number of market watchers attributed Wednesday’s 10-year Treasury yield move to fears about a global economic slowdown, heightened geopolitical unrest, growing worry over the Ebola health risk and uncertainty about Fed policy. However, while these factors certainly played a role, and especially contributed to stocks’ recent losses, I believe technical market factors, not fundamentals, were more to blame for Wednesday’s Treasury movement.
The extremity of the yield drop suggests it’s highly unlikely to have been caused by a wholesale reevaluation of fundamental economic conditions. Despite some weaker data releases Wednesday morning, U.S. economic growth is still in relatively good shape compared to the rest of the world. As such, in my opinion, the sharp decline in Treasury rates was largely the result of some large market players unwinding crowded trades in the Treasury futures markets, as they watched yields move differently from the expected road map.
As for what this all means for fixed income portfolios, there are a number of implications.
It’s clear that yields are likely in for a rocky ride as seasonal factors and technical unwinds of crowded positions play out in the weeks ahead, and as we get closer to a Fed rate hike, which should come sometime before mid-year 2015.
But despite the recent risk-off rate rally, as we work through the recent duress and get into November and December, rates will likely drift higher again as the U.S. recovery continues and Fed tightening nears.
However, the rise should be moderate given ongoing geopolitical turmoil and low rates in Europe and Japan. In part, it’s the very low rates in places like Europe and Japan that have increased demand for long-term bonds in the United States, supporting their prices and helping to keep yields low.
Ultimately, I see the 10-year Treasury yield finishing 2014 around 2.65% to 2.75%, though I see it trending higher to 3% over the intermediate term. Against this backdrop, investors may want to consider five bond moves.