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Bond veterans see nothing odd in falling US yields

Weak demand and inflationary expectations could keep those yields low for years

If you are convinced the plummet in yields of US government bonds is an aberration, it may be because you have not been in the business long enough.

With the longest-dated Treasuries now yielding less than half the 6.8 per cent average over the past five decades, it is not hard to see why forecasters say they are bound to rise as the Federal Reserve prepares to raise interest rates following the most aggressive stimulus measures in its 100-year history. Yet, compared with levels that prevailed in the half-century before that, yields are in line with the norm.

For David Jones, the former vice-chairman of research at brokerage firm Aubrey G. Lanston and a 51-year bond veteran, the notion that Treasury yields are too low is being shaped by traders, money managers and economists who began their careers in the wake of runaway inflation surpassing 10 per cent in the 1970s and '80s. With US consumer prices rising at the slowest pace in five decades and economic growth weakening around the world, today's bond market may now be reverting back to form, he said.

"We have come full circle," Jones, 76, said. "Rather than decrying how low interest rates are and expecting them to shoot higher, it may be that we're in more normal territory than we thought we were."

Since the financial crisis, yields on Treasuries of all maturities have fallen as the Fed attempted to restore demand in the United States by dropping its overnight target rate close to zero and buying bonds to suppress long-term borrowing costs.

The 5.1 per cent rally in US government debt this year has pushed down yields further, surprising those on Wall Street who anticipated the central bank's stimulus would lead to stronger economic growth, faster inflation and higher borrowing costs.

Yields on 30-year bonds, the longest-term debt securities issued by the US Department of the Treasury, have fallen a full percentage point to 2.97 per cent. At the start of the year, forecasters said they would rise 0.28 of a percentage point to 4.25 per cent.

Economists and strategists are sticking to their calls that yields will rise and predicting those on long-term Treasuries will reach 3.88 per cent next year.

Lacy Hunt, the 72-year-old chief economist at Hoisington Investment Management, says lacklustre demand and inflation were likely to keep yields low for years to come as the US contends with record debt levels.

Even though the Fed inundated the US economy with almost US$4 trillion of cheap cash with its bond buying, growth has averaged 1.8 per cent a year since 2009. In the seven expansions dating back to the 1960s, growth averaged almost 4 per cent.

Inflation has failed to reach the Fed's 2 per cent target for 30 straight months based on its preferred measure. The US consumer price index has risen an average of 1.62 per cent over the past five years, the least over a five-year span since the early '60s.

"Over time, what drives the bond yield is the inflationary expectations," Hunt said. "If you wring all the inflationary expectations out, you are going down to 2 per cent on the long bond over the next several years. That is the path that we are on."

Based on bond yields, inflation expectations over the next 30 years have fallen below 2 per cent and reached a three-year low of 1.96 per cent last month.

Those levels are more akin to inflation rates prevalent in the five decades after 1913. Living costs rose an average 2.45 per cent annually during that span, versus 4.3 per cent in the half-century since, according to Department of Labour data.

Long-term US bond yields were also lower in the earlier period, averaging about 3.1 per cent, according to Hoisington Investment Management data.

This article appeared in the South China Morning Post print edition as: Bond veterans see nothing odd in falling US yields
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