The year of the shrinking bond yield

Sabri Ben-Achour Jan 20, 2016

The year of the shrinking bond yield

Sabri Ben-Achour Jan 20, 2016

So far, 2016 has been the year of the shrinking bond yield. Today, yields on ten-year Treasury-notes closed below two percent.

The thing about bonds is that the more popular they are, the less you get out of them. 

“The more that people buy bonds, what they do is they drive the price of the bond higher,” explained Jim Paulsen, chief investment strategist with Wells Capital Management. 

The more expensive a bond gets, the more it eats into the value of the bond, the less the payoff and “that’s what drives the yield lower.”

One way to imagine it is as if you were buying a $10 coupon at the grocery store. If you had to pay $9 for a $10 coupon, you are saving $1. If you had to pay $9.50 for a $10 coupon, you’re getting just 50 cents.  This is what has been happening to ten-year Treasury bonds in 2016. 

“So the drop in ten-year yields that we’ve experienced this year is all about more and more people buying bonds driving their prices up and their yields lower,” said Paulsen.

The question now: Why is everyone buying these ten-year bonds? And why are they okay with shrinking yields? 

“Fear on wall street is on the rise,” said Michael Farr, CEO of Farr Miller and Washington. “When fear increases, people head to safety.”

In financial terms, treasuries are synonymous with safety. They’re backed by the U.S. government.

So why the desire for safety?  

“Well, how many reasons do you want?” asked Jay Morelock, economist with FTN Financial. “There’s a confluence of factors here.”   

For starters, there’s the overall dismal performance of the U.S. stock market; some brokerages have told investors to sell off stocks and cling to high-quality bonds. And there’s plenty of fear abroad. “Emerging markets are fragile,” said Morelock. 

China’s currency is weakening, and for those in China with debt denominated in dollars, a weakening Yuan “makes it much harder to pay that debt. So what we’ve seen is a big rush to the exits in the yuan,” said Morelock.

When one removes the fear component, the yield on the ten-year note is also partially a reflection of what investors think the Fed will do in the future. A ten-year note is something you can hang onto for ten years, so if you’re going to accept a yield that you’ll be stuck with for ten years (potentially), it means you don’t think something better is going to come along. That is, you don’t think the Fed will raise rates to the point that it will be a better deal to invest somewhere else in the future. 

The downward movement of ten-year yields means “the market is revising downward its expectations of how much the Fed will be raising rates,” said Joseph Gagnon, an economist with the Peterson Institute for International Economics.

“The market’s saying ‘ooh the world looks scarier than we thought so the Fed will probably not be raising rates as much as we thought,’” he said.

So what does the shrinking yield on the ten-year T note mean? It means investors are looking out ten years, and they’re still fearful. 

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