Where are the bond vigilantes?

John Osbon | September 7, 2011

(6 mins to read)

At the department store when a product is perceived as overpriced or of questionable long-term value, sales typically decline. Shoppers vote with their feet and go to a different aisle or a different store. But that’s not happening in the US Treasury market. Even with record low yields and record high prices, bonds continue to move. Where are the bond vigilantes, the big money buyers who are supposed to go on strike in protest of too much bond issuance?

As we write, the 10 year yield is 1.90%, a record low.  But as recently as February of this year, the yield was 3.75%. In six months yields have fallen virtually in half – truly astonishing in scope and speed.  While the 2% coupons won’t fund much of a retirement, the price return to those February buyers has been rich, a full 20 percent in fact.  No bear market there.

Yield on 10-Year Treasury Securities. Click image to enlarge. Source: St. Louis Fed

What downgrade?

In the middle of this surging bull market in US Treasury bonds, the full faith and credit of the US government was downgraded from AAA – an unprecedented event that garnered non-stop news coverage.  Downgrades almost always mean higher rates as buyers of bonds demand greater return for greater risk.  The downgrade happened on August 5th, when the yield was 2.4%.  Instead of rising, yields fell – the exact opposite of what conventional wisdom warned. The bull market charged on.

How long can it go on?

“It,” that is, low interest rates can persist for a long time, and rates can go even lower, as we have seen in the example of Japan.  The ten year Japanese bond sits solidly at 1.03%, and has been as low as .49%.  The yield has been at or below two percent since 2000. There are no time limits on how a market or economy will perform.

What next?

We don’t know the future of bond prices any more than we know the outcome of the next coin flip or the future of stock prices. Despite all the well-intentioned research and modeling that goes into forecasting future interest rates, the last six weeks should put to rest any notion of the predictability of rates. Tomorrow’s yields are based not on the prediction of experts, but on supply and demand. The recent bull market in bonds reminds us of the importance of diversification because you never know what asset class is going to outperform or when.  (See our article: “Which asset class will win next year?”)


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