Why I’m Predicting Lower Bond Yields

yieldBill Hall: If you own bond funds, you’ve no doubt suffered losses — maybe even big losses — over the past few months.

The Barclays U.S. Aggregate Bond Index has fallen 2.16 percent from the beginning of the year through last week. And a Barclays’ index that tracks 10- to 20-year U.S. Treasuries has sunk 6.35 percent. That’s as the yield on the benchmark 10-year Treasury has risen from 1.75 percent to just above 2.5 percent, with more increases on the way, economists and investors say.

But my advice is: Don’t abandon your bond funds just yet. That’s because the low in U.S. bond yields has yet to be recorded. I found supporting information compiled by Lacy Hunt, the chief economist at investment-management firm Hoisington Investment Management.

I realize that calling for lower yields in the quarters ahead puts me in the minority, as the wide-scale sell-off in the bond market attests. That’s why in today’s Money and Markets article, I’m going to provide you with two reasons why we’ll see lower rates for at least six months and probably 18 months. Next week I’ll reveal three more.

To start, it’s my view that the rise in long-term yields over the past several months was accelerated by the Federal Reserve’s announcement that it would soon be “tapering” its purchase of Treasury and mortgage-backed securities. That has convinced many bond-market investors that the low in long rates is in the past.

For interest rates to rise and stay there, faster inflation is, and has always been, the key factor.
For interest rates to rise and stay there, faster inflation is, and has always been, the key factor.

Inflation First

The Treasury market’s short-term fluctuations are the result of many factors, but the main and most fundamental determinant is the expectation for inflation. In other words, for interest rates to rise and stay there, faster inflation is, and has always been, the key factor.

Currently, there is no inflation in my forecast.

Inflation’s role in setting long-term rates was quantified by Irving Fisher 83 years ago (“The Theory of Interest,” 1930) with the Fisher equation, which says that long-term rates are the sum of inflation expectations and the real rate.

Since then, dozens of historical studies have reaffirmed that proposition. It can also be empirically observed by comparing the Treasury bond yield to the inflation rate, which have moved in the same direction about 80 percent of the time (on an annual basis) since 1954.

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Presently, the level of inflation is most favorable to bond yields. The year-over-year change in the core personal consumption expenditures deflator, an indicator to which the Fed pays close attention, stands at a record low for the entire five-plus decades of the series.

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Additional conditions restraining inflation are the appreciation of the dollar and the decline in commodity prices.

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