With all eyes glued to the Dow Jones industrial average as it flirts with record highs, an investor could easily miss a recent Treasury bill rally, which could have even broader implications.
Bonds are a classic “safe haven” investment, one of the asset classes investors run to when they fear an economic slowdown. As new data has shown a decline in home sales and prices, as well as other soft patches in the economy, investors have bid up the price of bonds.
Bond issuers, from corporations to the Federal government, pay more yield to entice bond holders at times when the price of bonds is plummeting. On the flip side, bond yields fall as the price of bonds rise. That’s what’s happened lately: Bonds have rallied and yields have dropped significantly, setting a new 7-month low last week.
At the end of July, the yield on 10-year Treasury bills was 4.98 percent. Friday, it was down to 4.63 percent, a massive shift by bond-market standards.
“The magnitude in the decline in yield really reflects a sharp shift in attitudes about the outlook for the economy,” said Michelle Girard, senior economist, RBS Greenwich Capital.
Just months ago, investors trying to divine the economy’s next move were worried about inflation, which is bad for bonds, since bonds’ fixed yields are eroded by inflation. But investors’ current fear is an economic slowdown. And the bond market loves a slowdown, which makes its fixed yields look solid and dependable.
A decline in bond yields puts downward pressure on interest rates in general.
“This should be a net positive for consumers,” said Paul Hickey, an analyst at Birinyi Associates Inc., a stock research firm.
Longer term bonds have had a stronger rally than shorter term bonds. As a result, shorter-term bonds pay higher interest than long-term bonds, a very unusual situation historically. The yield on six-month Treasury bills was 5.01 percent late Friday, while the yield on 30-year bonds was 4.76 percent.
Many loans with variable interest rates are tied to those shorter term bonds, so borrowers with variable loans might not see as dramatic declines as those with longer-term loans.
The benchmark 10-year Treasury yield is also lower than the Fed’s benchmark short-term interest rate of 5.25 percent. The 10-year yield forecasts where traders think the Fed will take rates, and it fell as traders began to predict rate decreases ahead.
“Expectations have dramatically shifted about the Fed, going from an environment where people expected tightening form the Fed, to one where they now expect easing,” said Jay Mueller, an economist at Strong Capital Management.
The descent in bond yields began two months ago. Yields slid further when the Federal Reserve held interest rates at 5.25 percent during its Sept. 20 meeting and the slide intensified on Sept. 21, when the Federal Reserve Bank of Philadelphia said its gauge of manufacturing activity in the Mid-Atlantic plunged in September, exacerbating worries that the housing slowdown will have broad economic impact.
Other factors besides the economic outlook are pushing bond prices higher.
“Over the last couple months, substantial amounts of foreign capital have come into the market,” said Rich Volpe, senior managing director and head of government bonds at Bear Stearns.
Yields in the U.S. remain better than those of other industrialized nations, said Tony Swindall, senior fixed income portfolio manager of the Private Client Group at National City Bank Corp. The benchmark notes in Italy, France and Germany all pay less than 4 percent.
At the same time, more currency is chasing a finite amount of debt. Since oil is sold in dollars, the high price of oil has left oil producing nations awash in “petrodollars.” And the U.S. trade deficit has also made our trading partners rich in dollars, which they are investing in the U.S.
Many players in the bond market feel yields are now too low.
“It’s often the case that the market overshoots to the upside and the downside — especially at times like this when you probably are near turning points with respect to the Fed,” Girard said.