A quick look at a timely topic of interest - with a brief review of why it could matter to investors.

Chart of the Week
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June 2, 2014

Yields: trouble ahead, or a boost to growth?
10yr US Treasury yields, initial unemployment claims and inflation expectations

chart

Source: Bloomberg, as of 5/29/14. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Bottom Line:

  • The decline in 10-year US Treasury (UST) yields since the start of the year has some observers worried, seeing the decline as a sign of a faltering economy.
  • But that worry flies in the face of many other economic indicators, including initial claims for unemployment insurance and inflation expectations, both of which are consistent with positive, if somewhat low-key growth.
  • More specifically, falling unemployment claims suggest the labor market continues to improve. And inflation expectations are stable, subdued and positive, in the range of 2.5% – inconsistent with the deflationary pressure expected in a slowing economy.
  • While the numbers contradict the belief that the economy is slowing, they also don’t necessarily imply that it’s accelerating—which might help explain the pullback in 10-year yields this year.
  • After all, yields rose about 140 basis points (bps) between May 2013 and January 2014 (from 1.63% to 3.03%) in part on expectations for faster growth – and are still 80bps higher than they were a year ago (as of May 29 2014).
  • Whatever the reason, low rates are good for economic growth, holding down borrowing costs for business.

The Chart:

  • The chart shows the 10-year UST yield (blue line), 5-year, 5-year forward break-even inflation (green shaded area) and the 4-week average of initial unemployment claims (broken red line) over the past year.
  • So far in 2014, UST yields have declined nearly 60 basis points from 3.02% at the start of the year to 2.43% on May 29th.
  • At the same time, the four-week average of weekly initial claims for unemployment insurance declined from 352,250 at the start of the year to a new cycle low of 311,500 in late May.
  • Meanwhile, the outlook for inflation over the next five years—represented by 5-year, 5-year forward break-even inflation—was 2.65% in late May, almost exactly where it was at the beginning of the year.

Context & Perspective:

  • Falling Treasury yields can sometimes be a sign of slowing economic activity and/or declining inflation expectations—in fact, we saw that happen in each of the temporary slowdowns that has occurred since the current recovery began nearly five years ago.
    • Yet during these previous soft spots, many other indicators were also consistent with slowing economic activity, but this time around they are not confirming the Treasury market’s signal, at least not yet.
    • In fact, there's growing evidence that the economy is picking up, including stronger national and regional manufacturing reports, moderately stronger new job creation, higher average hourly earnings, solid durable goods orders, more business lending and rising consumer confidence.
  • If lower Treasury yields are not signaling slower growth, what might the bond market be pricing?
    • It might be that growth will continue at a moderate pace instead of accelerating, as many hoped for last year.
    • It could also be a signal about a shift in expectations about interest rates and inflation—that both might remain lower for longer than expected even a few months ago.
    • Other potential influences: reallocation from stocks to bonds after a big run for equities; and rising foreign demand for US Treasuries at a time when supply is dwindling
  • Positive net inflows into mutual funds may also shed some light:
    • Investors have returned to the bond market after pulling back in 2013. According to the most recent data from the Investment Company Institute (5/21/2014), bond funds saw net outflows in excess of $117 billion for the 12-month period ended January 2014, while equity fund inflows were over $147 billion. But from February 2014 through late May 2014, net inflows into bond funds were a little around $39 billion, almost the same as the $41 billion that flowed into equity funds.
  • Rising foreign demand for US Treasuries amid a dwindling supply could also be playing a role in declining yields:
    • The disappearing US budget deficit means less issuance of US Treasuries; a marginal increase in foreign demand would have a bigger impact on prices now than when the Treasury was issuing greater amounts of new Treasury securities.
    • This year, according to the US Treasury Department’s international capital flow data (3/31/2014), foreign investors clearly stepped up: net foreign purchases of US Treasuries for the 3-month period ended March 2014 (latest data available) were the strongest since the 3-month period ended January 2013.

Definitions:

Initial claims for unemployment insurance is a measure of the number of jobless claims filed by individuals seeking to receive state jobless benefits. This number is watched closely by financial analysts because it provides insight into the direction of the economy. Higher initial claims correlate with a weakening economy

The 5-year, 5-year forward breakeven inflation rate is a measure of expected inflation derived from "nominal" Treasury securities and their "real" counterparts—inflation-protected TIPS securities.

A basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%).


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