A year ago, as Fed Chairman Bernanke spoke of the possibility of tapering the Fed’s Large-Scale Asset Purchase program (QE3), bond yields moved higher. They’ve been range-bound over the last year, but have more recently dipped to the lower end of that range. What’s driving the bond market?
The rise in bond yields a year ago was something of a puzzle. QE3 was not expected to last forever and the reduction of Fed purchases of Treasuries would be more than offset by the sharp reduction in government borrowing. However, there appeared to be confusion between the Fed’s asset purchase program and its forward guidance on short-term interest rates. Indeed, market participants began to price in an earlier increase in short-term interest rates. That’s not what the Fed intended.
Long-term interest rates normally rise in an economic recovery, which is why, at the beginning of 2014, most market participants anticipated higher long-term interest rates over the course of the year. Some expected a sharper rise than others, largely reflecting different views on the pace of the recovery. With many of the headwinds that had restrained the expansion now behind us, growth was poised for a pickup.
Weather was clearly a restraining factor for the economy in 1Q14. Growth is expected to be up sharply in 2Q14, and that appears to be baked into many of the economic data reports for April. However, the average pace of growth over the first half of the year will likely fall short of earlier expectations. That may explain much of the recent lower trend in bond yields. Yet, the near-term economic picture is clouded. Adverse weather, the rebound from adverse weather, and seasonal adjustment uncertainty (related to the late Easter holiday) have given us a muddled picture. There’s always some uncertainty in the monthly economic data (which are based on statistical samples), but recent numbers have likely been more distorted than usual.
Inflation is always a factor in the bond market. However, the spreads between inflation-adjusted and fixed-rate Treasuries suggest that inflation expectations remain well-anchored.
The Consumer Price Index rose 0.3% in April, bringing the year-over-year change to 2.0%. However, the Fed’s 2% target is based on the PCE Price Index, which is expected to trend somewhat lower than the CPI in the near term. Moreover, the CPI data show a very low trend in consumer goods, but a moderate pace in consumer services. The PPI picked up in March and April, but indices for the earlier stages of production suggest limited inflation pressures within the pipeline.
Soft data out of Europe (weak GDP, low inflation) and ongoing concerns about financial conditions in emerging economies (China and Brazil especially) have helped push bond yields lower worldwide. Developments in the Ukraine have likely contributed to at least a mild flight to safety in U.S. Treasuries.
Bond yields may test the lower end of the range amid data distortions, but the economy is likely to remain on track for better growth in the second half of the year.