The reason can be summed up in four initials: F O M C (The Federal Open Market Committee).
The FOMC (part of the Federal Reserve System) establishes monetary policy. Meeting eight times a year, they determine the targeted federal fund rate–which is the yield at which banks lend amongst themselves on an overnight basis. The fed fund rate is the main tool that the FOMC utilizes while attempting to meet its dual mandates of economic growth and price stability.
Recent releases of Gross Domestic Product indicate that the FOMC has met the first goal with the actions implemented over the past three years. The U.S. economy is growing at an inflation-adjusted rate between 2.50% and 3.50%. Given productivity and demographic trends, this range incorporates the likely growth rate for the coming years.
Price stability has been the more difficult goal to attain. Historically, high inflation and deflation have been difficult environments to manage. High inflation, or more drastically hyperinflation, leads to exaggerated purchases of items since they are likely to be more expensive in the future. Fixed rate lending becomes difficult since the interest rate charged may not compensate the creditor for inflation that may be experienced between the time the loan is originated and the repayment of principal. This can lead to a slowdown in economic activity since it is riskier for businesses to form or expand. From the late 1960s to the early 1980s, the U.S. experience a period of high inflation with two peaks of over 10% as measured by the price index for personal consumption expenditures (PCE), the inflation indicator targeted by the FOMC. Both of these peaks, in 1974 and 1980, led to rising unemployment as deep recessions took place. The Committee had to implement very high fed fund rates, as high as 20%, to reduce inflationary pressures to more acceptable levels.
During periods of deflation, households and businesses tend to hold large cash balances to defend against balance sheet problems. They also defer purchases since the price of certain items will usually be cheaper in the future. This practice reduces economic activity and leads to recessions. During 2008 and 2009, there were periods of deflation. It has taken significant reductions in the fed fund rate and massive amounts of bond purchases to reduce deflationary pressures.
Since January 2012, the FOMC has targeted long-term PCE price increases of 2.0% to fight deflation. As the chart below indicates, the Committee has had mixed results attempting to meet their objective. Given that inflation started to decline in 2011 and 2012, the FOMC implemented their third round of quantitative easing (QE3) in September 2012 and doubled it in December 2012—following earlier programs that were initiated during the height of the Great Recession in November 2008. QE3 added stimulus to the economy by buying government bonds (mainly government agency mortgages), which increased the U.S. money supply. The hope was that eventually these funds would be spent on products and services resulting in a decrease in deflationary pressures (and a boost to the economy). This stemmed the fall in inflation and caused some rising price trends in early 2014.
As the FOMC was declaring victory in February 2014 by tapering bond purchases, another factor became important for price inflation. As the chart below indicates, the U.S. dollar took off due to concerns about economic growth slowdowns in non-U.S. economies and an oversupply of commodities priced in U.S. dollars, especially oil. The dollar rise resulted in greater purchasing power for U.S. consumers and businesses, which was good for economic growth. But it also decreased prices for foreign goods that are exported to the U.S. (energy, for example) and made it difficult for U.S. produced goods to compete (agricultural commodities.) This led to a further drop in inflation into 2015.
All of this had benevolent effects on the U.S. interest rate market. As the 30 year Treasury bond yield chart below indicates, bond yields fell from over 4.50% in early 2011 to 2.50% at the beginning of this year. They reversed and rose this year on the possibility that the FOMC would start raising rates soon (first in March, then in June, then in September and now in December). But notice that the rate peaked in June and has fallen since then. It is becoming clear that the FOMC is not going to raise rates while the PCE price index is below 2% and declining. The recent third quarter release of this measure confirms that this is our current environment.
Another way to measure the FOMC’s efficacy in meeting their inflation goals is examining long-term inflation expectations. Below is a spread chart of 5 year Treasury note yields and 5-year Treasury-Inflation Protection Securities (TIPS) yields. By taking out the inflation-adjusted or real yield portion of Treasury yields (as measured by TIPS), market-based expectations of inflation can be obtained. As the chart above indicates, inflation expectations continue to fall and are at levels not seen since the Great Recession in 2009.
We are now in a bullish position in US Treasury securities. The market has assigned a significant probability of the FOMC rising fed fund rates in December 2015 and strong likelihood of an increase by March 2016. Given the analysis above we believe that fed fund rates will not increase until June at the earliest. It is likely that the Committee will avoid the Presidential election cycle and not raise rates until December 2016. If the latter become evident, we believe that the 30-year Treasury will test the 2.25% lows of earlier this year, a 70 basis point drop from current (10/29/2015) levels. Since the 30-year Treasury has close to 20 years in duration, we expect a 14% (20*0.70) increase in the price of the bond on top of the 2.95% coupon rate being earned.