Over the past few weeks we have seen mostly positive economic reports and improvement in Europe (yields of Italy and Spain have dropped below 6%). As expected the stock market has been rising steadily and the S&P 500 is close to a yearly high (NASDAQ is already at a new yearly high and at the highest level in 11 years). In light of these circumstances one would have expected that Treasury bond yields would have risen up a reasonable amount also. But we are not seeing that. Typically treasury yields move down when their is a flight to safety or decreasing inflation. In the current scenario you have risk coming down and data to support an improving economy. Other asset classes like Stocks and commodities are behaving as expected that their prices are going up. The 10 year treasury yield as of today is around 1.95% which is near the lower end of the range for the last 6 months, whereas stocks are comfortably at new 6 month highs. If treasury yields would have not broken down their correlation with stocks, they should have probably been in the 3% range by now.
So what is really happening. Here are a few reasons why I think this divergence is happening and I will order them based on what I think is the most probable cause
- I think the main reason for this behavior in bond yields is the Fed. The Fed is suppressing yields in two ways. First, through Operation Twist the Fed is selling shorter term bonds and buying longer term maturities to push those rates down. The Fed is soaking up some of the supply of these bonds so they have artificially suppressed the yields for these long term maturities. Second, just recently the Fed openly revealed that their current view is to keep short term interest rates near Zero till 2014. By declaring this they have seduced bond traders into thinking that they don’t face much interest rate risk in the medium term.
- The other possibility, although I don’t strongly believe in it, is that the bond market traders are thinking differently than stock market traders. It is possible that the bond market does not believe in the current economic strength and feels we will head back into economic weakness pretty soon and we might again face possibility of deflation.
I think a lot of traders feel that the fed has committed to keeping interest rates near zero till 2014, but in reality this is just their current viewpoint. The Fed can easily change its view with new data, so traders shouldn’t read too much into this 2014 forecast.