Fed Tapering Won't Cause a Bond Market Armageddon

Yields on the 10-year Treasury jumped after the Federal Reserve said it could begin tapering its monetary stimulus later this year.

But even if the Fed scales back its pace of bond purchases in the second half of 2013, investors shouldn’t expect rates to finish the year much higher than where they are today. My expectation is that by year’s end, the yield on the 10-year Treasury will be trading somewhere between 2.25% to 2.5%.

This is because there are a number of factors conspiring to keep rates low even if the central bank slows its buying. Here’s a look at three.

1.) The Supply and Demand Situation for Treasury Securities. Some market watchers fear that Fed tapering would lead to excess Treasury supply, which in turn would result in higher rates. However, in a recent research report published on Seeking Alpha, my colleague Antti Petajisto drills down into Treasury supply and demand to explain why this scenario isn’t likely.

On the Treasury demand side, Antti points out that foreign central banks are big buyers of Treasuries, i.e. the Fed isn’t the only large player in the Treasury market. Meanwhile, on the Treasury supply side, he notes that a rapidly shrinking Federal budget deficit is leading to reduced Treasury issuance.

Ultimately, Antti expects that by the time the Fed ends its stimulus, the Federal deficit will have fallen far enough that any new Treasury supply will almost match demand from foreign central banks (at least for the next couple years). The bottom line: Even with less Fed buying, modest net new Treasury supply suggests yields won’t rise dramatically in the next year.

2.) Aging demographics. As populations age, real-interest rates tend to be lower. In addition to contributing to slower growth, an older population generally borrows less and has more demand for fixed income instruments.

3.) The still anemic nature of the recovery. With households still deleveraging and corporations flush with cash, there simply is not much demand for capital from the private sector. And as I wrote in a Market Perspectives paper last year, slower growth and less demand for capital have historically been associated with lower real interest rates.

To be clear, I expect interest rates to continue to rise this year and into next. However, given the reasons I cite above, I expect that the rise in yields is likely to be slower and more tempered than many expect.

Source: Bloomberg, BlackRock research

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