Supply, Demand and Interest Rates: Why One Thing Leads To Another [iShares Trust, iShares iBoxx $ High Yid Corp Bond (ETF)]

ratesAs we approach the mid-point of the year many casual investors are surprised to look in on the market and find that bond yields remain stubbornly low. In fact, as we have discussed in this space before, they have actually fallen during the year with the 10 year US Treasury declining from 3.03% at the end of December to 2.63% as of June 9th. And it turns out that this overall decline in yields has occurred across global bond markets.

There are a lot of drivers of lower yields, including the continued accommodative policies of central banks and the continued slow growth in GDP and inflation in most developed economies. All of this comes together in net bond demand, which is how much demand there is for bonds relative to supply.

The Fed’s QE program has been a big part of this, as it has created additional demand and has helped to push interest rates down. Today I wanted to take a closer look at the broader supply/demand picture.

A recent JP Morgan report noted an interesting statistic: in 2013 the new global bond supply was $200b more than demand.

The data came from the Federal Reserve’s quarterly Flow of Funds report. The report’s observation was that this excess supply coincided with higher global interest rates in 2013.

The same relationship played out in reverse in 2011 and 2012, in both years demand was greater than supply and in both years global interest rates fell. This relationship is fairly intuitive.

When demand exceeds supply in any market, prices are driven up.  In fixed income this means that prices are pushed up and yields are pushed down.

The same mechanic plays out in reverse when supply exceeds demand.  Prices fall, and for bonds falling prices result in higher yields.

This insight helps explain the 2014 bond market. In Q1 2014 supply was insufficient to keep up with demand, and the report estimates that for all of 2014 demand will outstrip supply to the tune of $460 billion.

There have been many drivers of the year-to-date buying including retail investors, banks, and foreign entities.

We’ve seen this trend in fixed income ETF flows with $18b coming into funds globally as of last month.

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