By Malay Bansal

The overlooked reason behind the U.S. Treasury yield’s seemingly irrational behavior.

2014 started with ten year treasury yield at 3% and almost universal expectation that it was going nowhere but up from there (Treasury Yield Forecast for 2014 Climb to Survey High of 3.41%). Yet, confounding everyone, it has done exactly the opposite. Defying everyone’s expectations, it has steadily gone down since the beginning of the year and has been around 2.50% recently!

The underlying logic for expecting yields to go up is sound. As expected, the economy is slowly but surely improving. GDP has been growing. The unemployment rate is coming down. All 8.7 million jobs lost during the recession have been gained back. The unemployment rate is down to 6.2% from 10.1% in 2009. Even underemployment (U6) is coming down and is below 15% now, down from 17.5% during the recession. Inflation numbers are firming. Stock markets are back to previous highs. Real estate prices have recovered a lot of the ground lost during the recession. With the economy improving, and asset prices going up, yields should not be at such low levels.

Also, as expected, the Federal Reserve is tapering its bond buying program (QE3), and is going to end it by October this year. Under QE3, the Federal Reserve was buying $45 billion of treasuries (and $40 bn of mortgage bonds). With QE3 ending, a big source of demand is going away, which is another reason for yields to go up.

All rational logic suggests that yields should have gone up this year, not down! So, does the fact that yields have come down instead indicate an irrational behavior on the part of bond buyers? The behavior clearly has the experts baffled (see U.S. bonds confound experts as yields fall, Street baffled as 10-year bond yields hit lowest in six months, Cramer: Baffled by where interest rates are – CNBC).

Several different explanations have been provided by market experts for this (see Why the World Still Loves U.S. Treasury Debt, Bill Gross says this is what’s really behind the Treasury rally). However, in my opinion, one key reason has not been recognized or understoodthe role played by increased availability of information, a concept I refer to as Information Momentum (see Using Information Momentum to Understand Markets & Economy), which has a big impact on behavior of market participants.

To understand the link between the two, consider that the signs of improvement in the economy and job market are clear and evident. Everyone can see that the economy is improving and asset prices have gone up. Though forecasts have come down, yields are still expected to go up from here. Almost everyone believes that rates will be higher in future, although most people also believe that yields are not going up immediately and the start of rate increases is a few months away at the least, as the Federal Reserve has clearly stated that it intends to keep interest rates low for a “considerable time” after ending bond purchases. With the easy availability of information, most people (including, and especially, professional investors and bond buyers) believe that they will know when the rates start moving and will be able to act quickly. The changes at Fed to be transparent in its communications started by Ben Bernanke have had a positive effect generally by reducing uncertainty, but as a result, everyone has higher confidence in their ability to know when the Fed will act to raise rates. It is an obvious and well-recognized fact that when yields go higher, bond values will go down. People will reduce their bond holdings once yields start going up and portfolios start showing losses. However, they do not perceive a need to act now. Compared to the past, a lot more people now, have a lot more confidence in their ability to know quickly and act at the last minute (“Just-in-time decision making”) when yields really start going up. This is an important reason why market participants have not acted on their belief that yields will be higher in future, and that lack of action has resulted in the yields staying lower than they otherwise would be.

If you agree with the above logic, the lower yields are not a result of irrational behavior on the part of market participants, but just a manifestation of change in timing of their actions. Also, there are important implications for future. If everyone believes that they can act at the right moment and do not have to act earlier than that, and most people have the same sources of information, then that means, a lot more people will come to same conclusion at the same time. That will lead to a lot more people acting at the same time. If a lot more people are trying to sell their bonds (or bond funds) at the same time, it will result in a sudden big jump in yields. We saw an example of this in May-June 2013 when 10 year yields jumped up by over 100 bp in a span of two months!

It also has important implications for the Fed. In the past, with somewhat cryptic Fed-speak, which left people guessing on the timing of rate increases, different people had different opinions on timing of rate increase based on their differing interpretations of the Fed pronouncements. That moderated the speed at which the yields moved higher as some people acted earlier than others. This time, Fed’s transparency makes more people more confident they know when rates will start going up, increasing the risk of sudden jump in yields, which can be bad for the economy and markets. Janet Yellen (whose husband, George Akerlof, a University of California, Berkeley, professor, won the Nobel Prize in economics in 2001 and played a role in behavioral economics) and the Fed have their work cut out for them to manage the rate at which yields go up. Actions from the Fed that will raise doubts about timing of rate hike will actually be helpful in this regard. It will not be surprising to see more members of the board dissenting and offering differing opinions, which is one way to introduce some doubt about the timing of the rate increase.

The other thing that the Fed can do to moderate the speed of rise in yields is to adjust their timing to when there is higher demand for U.S. treasuries. Since the US economy is a little ahead of Europe and other developed nations in recovery, the US Dollar is seen to have a positive outlook compared to other currencies. That attracts capital to US treasuries. As other economies recover, the relative attractiveness of the dollar may lessen. This would suggest that Fed will be better off raising rates sooner than later, if the economy continues improving.

Complicating Fed’s decision is the risk of derailing the growth by hiking rates too early, which may cause the Fed to delay action. However, the delay will probably mean a bigger and faster rate rise when they do start raising rates.

The conclusion on the outlook for rates is similar to that in my article (What’s Ahead for US Interest Rates?) last year, though economy has improved measurably since then and is undoubtedly growing. As the economic growth picks up or inflation rises, yields will go higher, and even though it is difficult to predict when yields will start increasing, it is easy to see that when yields do start increasing, the increase could be very rapid and significant. The implications for investors are (i) to not wait till the last minute, but act sooner to adjust positions and portfolios, and (ii) be careful when using strategies that depend on the timing of yield increases to be right.

Note: The views expressed are solely and strictly my own and not of any current or past employers, colleagues, or affiliated organizations.

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By Malay Bansal

A simple concept that is useful in understanding some counter-intuitive phenomena in markets and economy, and looking ahead to the future.

For over a decade, I have used a concept that I have called Information Momentum in my thinking and discussions to explain phenomena in markets and economy that otherwise do not seem completely intuitive. Understanding why something has been different from expected in the past also helps in understanding and looking ahead to what might happen in future.

At its core, the concept is simple and parallels the similar concept in physics. Every physical object has a mass, and if it is moving, it has a velocity. The product of the two is known as momentum. The higher the momentum, the greater the impact that object will have. The higher the momentum, the higher the force required to stop the object from moving or to change its direction.

A somewhat similar concept can be applied to information. In this case, consider the number of people who receive a new piece of information, and can act on it, as equivalent to the mass, and how fast people get this new information as equivalent to velocity. The more the number of people who receive the new information, or the quicker the new information reaches people, the higher the information momentum for that information.

The concept is simple and so are some observations which help apply the concept to understanding market behavior. Somewhat in jest, and continuing the parallel with physics, I have sometimes referred to them as my laws of information momentum. Four of these observations are mentioned below.

First law of Information momentum is that the information momentum will continue to increase with time. This is obvious today. It started increasing with with internet becoming more easily available to more people, first in US and then around the world. Then, each of the following, as it came on the scene, has contributed to a quantum jump in the information momentum: advent of the web (the world wide web), email, blogs, news sites, internet trading, faster connection technologies like DSL replacing old phone dial-ups,  wi-fi connections everywhere, tablets & smartphones with data connection, twitter. This trend will continue and the increase in information momentum will magnify the impact of the other laws.

The second law is that higher information momentum means new information will have bigger impact than in the past. More people acting on a piece of information at the same time means bigger moves in market and possibly more often. A corollary to this law is that higher information momentum can, though will not always, increase volatility and correlation in markets.

 The observations by Bespoke Investment Group on “S&P 500 All or Nothing Days” (days where the net daily A/D reading in the S&P 500 exceeds plus or minus 400) as described in the article All or Nothing Days Becoming More Common Than Uncommon, and as shown in the chart below provide a good example of this over a long period.

S&P500 All or Nothing Days Graph

Source: Bespoke Investment Group.

The third law is that more information momentum means better decisions will be made. Better decisions will logically lead to better outcomes, which in bigger picture, implies higher probability of higher profits for companies and better growth for the overall economy. All else being equal, the future will be better than the past. This applies at every level including at the level of individuals, companies, countries, local markets, and the entire world’s economy. At every level, decision makers will have access to more specific and detailed information and sooner than ever before. In addition to more detailed information about the specific situation, decision makers will have access to more ideas, viewpoints, opinions, suggestions, and criticisms from a wide variety of people through blogs, comments etc. As an example, in 2008 and 2009, when the economy worldwide was facing a huge crisis, with declining values of mortgage backed securities and other bad assets  leading the biggest banks towards failure, and the government had to announce extraordinary measures like TARP, even people like me were able to chime in with suggestions directly to people at Treasury and Federal Reserve and via articles in New York Times etc (to toot my own horn, I suggested a plan involving public-private partnership – basically the concept behind TALF and PPIP programs announced and implemented several months later. See Solving The Bad Asset Problem or PDF).

It is easy to see that even with all else being equal, the future will be better than the past. But all else is not equal, if you look at things like what developments like search engines have done to personal and business productivity. You can find answers to almost any question you have just by googling it. Think about how Google Earth has changed the real estate businesses, and other similar examples. All of these are reasons to be optimistic about the future.

The fourth law states that since more information may become available with time, decisions will be made later in time, possibly at the last possible minute when they have to be made. At an earlier time, the Just-in-time concept significantly improved productivity in manufacturing. In a similar vein, decisions to act may be delayed till the last minute so as to take advantage of any additional information that may become available (what I call “Just-in-time decisions”).

Future articles will add more laws and give more specific examples detailing the application of these concepts for understanding various market and economic developments and looking ahead to the future (for the first example of application of these concepts, see Why have U.S. Interest Rates Defied Expectations and What Lies Ahead? ).

Note: The views expressed are solely and strictly my own and not of any current or past employers, colleagues, or affiliated organizations. My writings are simply expressions of my intellectual thought process. I welcome comments, observations, examples and any extensions of the concepts above.

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