As we approach the mid-point of the year many casual investors are surprised to look in on the market and find that bond yields remain stubbornly low. In fact, as we have discussed in this space before, they have actually fallen during the year with the 10 year US Treasury declining from 3.03% at the end of December to 2.63% as of June 9th. And it turns out that this overall decline in yields has occurred across global bond markets. There are a lot of drivers of lower yields, including the continued accommodative policies of central banks and the continued slow growth in GDP and inflation in most developed economies. All of this comes together in net bond demand, which is how much demand there is for bonds relative to supply. The Fed’s QE program has been a big part of this, as it has created additional demand and has helped to push interest rates down. Today I wanted to take a closer look at the broader supply/demand picture.
A recent JP Morgan report noted an interesting statistic: in 2013 the new global bond supply was $200b more than demand. The data came from the Federal Reserve’s quarterly Flow of Funds report. The report’s observation was that this excess supply coincided with higher global interest rates in 2013. The same relationship played out in reverse in 2011 and 2012, in both years demand was greater than supply and in both years global interest rates fell. This relationship is fairly intuitive. When demand exceeds supply in any market, prices are driven up. In fixed income this means that prices are pushed up and yields are pushed down. The same mechanic plays out in reverse when supply exceeds demand. Prices fall, and for bonds falling prices result in higher yields.
This insight helps explain the 2014 bond market. In Q1 2014 supply was insufficient to keep up with demand, and the report estimates that for all of 2014 demand will outstrip supply to the tune of $460 billion. There have been many drivers of the year-to-date buying including retail investors, banks, and foreign entities. We’ve seen this trend in fixed income ETF flows with $18b coming into funds globally as of last month. Obviously these trends may not continue in the way the projection describes, but this imbalance does go a long way towards explaining why interest rates have fallen so far in 2014.
So what does this mean for investors?
- The demand we have seen for fixed income this year is a significant contributor to lower interest rates. The demand is coming from retail investors through mutual funds and ETFs, as well as institutions and government bodies like the Fed.
- Changes in this supply/demand picture will go a long way towards determining where rates go, especially shifts by central banks. As Russ recently pointed out, the Fed is now midway through their tapering down of Treasury and MBS purchases, and our expectation is that they will have ended the program by the end of the year. This is in contrast to Japan, which continues their asset purchase program, and the ECB, which stepped up last week to increase liquidity and may be moving towards a form of QE. Even when the Fed is out of the picture, continued strong bond demand from foreign central banks and investors could keep rates in a low range. We believe that the 10 year US Treasury will likely move towards 3% by year end, but it’s doubtful that it will rise significantly above that level. The supply/demand picture just doesn’t make this likely. Yes the Fed will continue to taper, but other investors are expected to step in and fill the gap. The Fed isn’t the only bond player in town.