As 2013 drew to a close, investors bid up “risky” assets and sold “safe” assets in anticipation of a robust 2014. “Risky” stocks rose 30 percent and the “safe” 10-year Treasury bond lost 4 percent.
As we near the halfway point in 2014, something strange has occurred. The stock market has continued higher up over 4 percent, but the 10-year Treasury has also returned 4 percent, as yields have fallen. After finishing the year at 3 percent, the 10-year Treasury yield stands at 2.4 percent, a far cry from the 3.5 percent many investors anticipated.
With the Fed decreasing bond purchases and the economy growing, shouldn’t rates be rising?
The Economic Growth Case
Investors bid up interest rates late in 2013 on expectations of accelerating economic growth. Surprisingly, U.S. GDP in the first quarter declined 1 percent, the worst performance in three years. This has been explained away by extreme weather, but for full-year estimates to hit the mark, the next three quarters will need to be above initial estimates. Specifically, GDP must grow over 4 percent in the second half of the year for the full year to reach the 3 percent expected at year-end. Lower than expected economic growth invites lower than expected yields.
The Inflation Case
The Fed has a 2 percent inflation target that they associate with healthy economic fundamentals. They have forecasted a 1.5 percent rate for 2014. Inflation hit 1.09 percent in February, not far from the lowest levels since the recession. Lower than expected inflation invites lower than expected yields.
The Technical Case
Consensus within the trading community that interest rates in 2014 would increase led to significant bearish bets on bonds. Every down-tick in yield produces losses for those betting on rising rates. With commodities, equities and traditional bonds all producing gains, taking losses on a negative interest rate bet makes professional investors pretty unpopular with clients.
As such, the incentive to reverse these positions and repurchase yield exposure increases demand for Treasuries, pressing yields even lower. Concurrently, the amount of new Treasury supply has plummeted this year as the Federal deficit has shrunk. Treasury issuance year to date has fallen 59 percent. Higher Treasury demand and lower than expected supply invites lower than expected yields.
What Goes up When Yields Go Down?
With the fundamentals and technical conspiring to lower yields, who wins? Assets with healthy yield streams. Reits, utilities, preferred stocks, master limited partnerships and high dividend equities have all handily outperformed. To this point in the year, if you populated your portfolio with these high-yielding assets, you are a winner.
However, the same forces that conspired to push yields lower may soon reverse. Growth rates in the second quarter should be markedly higher. Inflation pressures from wages and commodities may push core inflation rates higher. Treasury issuance should increase, and the downward pressure on yields from forced buying by hedge funds will dissipate.
While the bottom for yields in 2014 may lie lower, the case for higher year-end yields appears strong. As such, “safe” assets may once again turn “risky.”
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.