Why US interest rates are heading lower
The whole world is suddenly in love with the 10-year Treasury note, and for U.S. consumers that could mean lower rates on mortgages and other loans.
Since the turn of the year, the 10-year yield has taken a stunning journey below 2 percent, and looks set to break the 1.87 percent yield it briefly touched in a mid-October selloff. The yield, at 2.17 percent at the end of December, was as low as 1.88 percent in early afternoon trading Tuesday, a level it has not closed at since May 2013.
The 10-year loosely influences mortgage rates, and a 30-year fixed-rate mortgage for the best credits was at 3.76 percent Tuesday.
Strategists have been expecting the 10-year to end 2015 with an average yield of roughly 3 percent, but it now looks as though some of those forecasts will be revised as yields extend into a new lower range. One factor driving them has been the plunge in oil prices, off sharply Tuesday.
They note that while yields at the long end of the curve have fallen sharply, yields at the shorter end have not moved as much, reflecting the view that the Fed will raise short-term rates later this year. The 30-year Treasury yield, meanwhile, fell below 2.5 percent Tuesday for the first time since July 2012.
Another reason buyers are piling into longer-dated U.S. Treasurys has been the relative attractiveness of U.S. yields, compared with other sovereigns.
"When you see Japanese rates at 28 basis points (0.28), it's not a surprise Japanese investors like Treasurys, and the same is true of European investors," said George Goncalves, head of rate strategy at Nomura. German 10-year bunds were at 0.44 percent Tuesday, and the five-year has had a negative yield since last week.
"What we're seeing is proof positive that we live in a very globalized market, and it's nowhere truer than in the bond market, where the flows are cross border," Goncalves said. "They're indiscriminant. They're not based on country bias. They're looking for the highest yield."
Strategists also expect yields to stay low for months to come because of the influence of global markets.
"The overriding point is there's excess capital looking for a place to call home, a place to invest, and since it's a relative game, U.S. yields look attractive," said Tony Crescenzi, Pimco market strategist and executive vice president. "Also, given the U.S. dollar has been rallying, it's a kicker. That tops off the trade. Not only can you achieve a higher-yielding investment than in Europe, but you can also have the benefit of a rising dollar. The trade will work until it doesn't. It will at some point get crowded. In trades like this, when sentiment is one-sided, it can last longer than you think."
Investors were also jumping into Treasurys as a safe-haven bet, as stocks sold off and falling oil prices made for jitters about deflation and slowing global growth.
Goncalves said there's a tug of war in the Treasury market between U.S.-focused investors who see an improving economy and stronger dollar as a reason for higher rates. Those investors are responsible for the near record level of shorts in Treasury futures, and they are pitted against global investors seeing a relative value in the U.S. Treasurys and slowness in the world economy.
David Ader, chief Treasury strategist at CRT Capital, said rates could continue to move lower and should stay low for some time. He said he may revisit his year-end 10-year yield target of 2.65 percent which he forecast when oil prices were still in the high $60s. West Texas Intermediate futures for February were trading at about $48 per barrel Tuesday.
"At the moment it looks too high," he said. "I may have to be talking about a 1.50/1.75 lower end of the range and that simply because we will be driven by the lower rates in Europe," he said. Ader said the dollar could actually end up trading at parity with the euro—at 1.18/1.19 Tuesday—and that would drive 10-year yields to 1.50 percent.
Cliff Noreen, president of Babson Capital, expects the 10-year to yield in a range of 1.50 to 2.50 percent this year.
"I concur with the views that we're going to see lower rates more from looking at a relative value basis across the globe," said Noreen. But he said the collapse in oil prices is something that concerns him. "I'm worried about it economically. Every investment and management firm is looking at possible impacts to their portfolio, their clients and they're trying to get a handle on it."
Market anticipation of a new European Central Bank quantitative easing program has helped drive European—and U.S.—rates lower. The ECB meets Jan. 22, three days before general elections in Greece, another factor setting markets on edge.
"I think the ECB is being way overemphasized as a relative topic. We look at Germany having a negative five-year rate. If they do QE, how much lower can rates go?" he said.
Pimco's Crescenzi said while the decline in yield has more to do with global forces, there are other factors.
"One thing we've thought through for a long time is the supply of safe assets globally has been shrinking in the trillions of dollars," he said, noting sovereign ratings downgrades have contributed to that. "Also, the U.S. budget deficit has fallen sharply this year. It will be under $500 billion, so the issuance of Treasurys has diminished at a time when global demand for safe assets has increased because of global volatility."
Crescenzi does see rates at the long end staying unusually low for some time, but not this low.
Crescenzi said the 10-year yield has moved away from fair value. "We think it has moved beyond its fundamental value at these levels but we recognize the global forces in play," he said. "It would be surprising if it stayed below 2 percent this year." The 10-year started 2014, yielding 3 percent.
Goncalves said another factor that could keep rates low is the large short position in Treasury futures. He said there are $28.7 billion in short positions across the Treasury futures complex, just below a level of $29 billion in mid-December, the highest level post-financial crisis.
As shorts cover, they could help drive rates even lower. Goncalves said the next target the market will look to hold is 1.85 percent.
Goncalves said the Treasury market may be more dramatic since the start of the year but the reasons behind the trading are not new. "People have woken up and they're pretty grumpy. It's a grumpy start for the year."
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