Searching for Meaning in Bouncy Bonds

Here are some sentences that don't make sense: "German two-year debt yields held close to 15-month lows just below zero on Wednesday, with record low money market rates and expectations of easier ECB monetary policy underpinning demand at an auction of similarly dated bonds." "Eurozone government borrowing costs sank to historic lows on Thursday as investors increased bets that the European Central Bank would take aggressive action to avert a deflationary slump, following early data indicating that the region's recovery slowed in August." "Portuguese and Spanish government bonds rose, with two-year notes leading euro-area rates to new lows amid speculation stubbornly low inflation will prompt the European Central Bank to extend stimulus measures." Here is why these sentences don't make sense: If you expect the ECB to increase inflation, you probably don't want to own low-yielding bonds. Or bonds paying no interest during their two-year lifespan.^[i] In reality, bond buyers could be speculating the ECB won't do anything! But you won't get that theory from the media's misperceived explanations for short-term market movement-usually something you can't tie to any one, two or three things. It's a timeless lesson but particularly apt these days, with the punditry desperately searching for meaning in the recent slide in US Treasury yields.

It is human nature to want to know why markets move the way they do. It is also human nature to want an answer more specific than "because," even though "because" is right the vast majority of the time.^[ii] To most folks, "because" feels like a cop out. I promise you it isn't.

This is why: Billions of shares change hands each day, via several million unique transactions. That means millions of people (and computers) trading for millions of reasons.^[iii]Fund managers buying and selling to accommodate additions and redemptions. High-frequency traders buying because a price moved a certain way or because a certain economic data point moved up or down. Retirees selling a few shares just to fund their living expenses. Workers buying to put new 401(k) contributions to work. People panicking. People buying because they think panic is overblown. Taking stop losses. Buying on the dips. Cashing in so you can buy a house. Selling your house and reinvesting the proceeds. I could come up with loads more, but you get the drift.

This brings us to the subject of interest rates. Particularly the 10-year US Treasury rate, which has fallen all year. Something most thought wouldn't happen while the Fed "tapered" its quantitative easing (QE) program. And most can't accept that this nearly eight-month trend can't be mere noise, volatility, just because. So they reach for causes. Like geopolitical instability prompting a flight to safety. Or bond markets pricing in a weakening economy. Or foreign governments buying more Treasurys. It might even sound plausible! Even though rates rose last year as tensions raged in Syria and Egypt, US growth is accelerating, and foreign governments were buying at about the same pace while yields were rising, too.

The simple truth is there is nothing extraordinary about what 10-year yields have done this year. The spread between the year-to-date high and low is the smallest in 40 years. Yes, the Fed is winding down, but markets are forward-looking-bond markets started discounting the taper around the time former Fed head Ben Bernanke first alluded to it on May 22, 2013. The 10-year yield was 1.94% when markets closed the day prior. Less than four months later-September 6, to be exact-it was a full percentage point higher. It finished the year at 3.04%. They're down now but still about half a point higher than pre-taper talk.

And that last factoid is what really matters here, because it means the end of QE should still be a positive even though rates have fallen this year. The yield curve is still steeper today than pre-taper talk, which still gives banks an incentive to lend more. And they appear to be acting on that incentive, as loan growth has accelerated nicely this year. And the yield curve spread-the difference between short-term and long-term rates-is still a bigger driver of the Leading Economic Index than it was pre-taper. Tellingly, its contribution to LEI growth has barely budged all year. No drag here.

Looking for meaning in recent volatility is looking backwards-it tells you nothing about the future. What matters most is fundamentally, there are no huge reasons yields should tank from here and flatten the yield curve. Growth is speeding up. Inflation is picking up. Rates probably won't jump a bunch, but a slight drift higher over the foreseeable future looks far likelier than not.