If there is one thing that every investor should understand, it is that often the conventional wisdom on Wall Street just doesn’t play out. A prime example of this situation is the downtrend in interest rates so far in 2014.
At the beginning of the year, the U.S. Federal Reserve began the much-talked about “taper” of quantitative easing, or QE. So far, the Fed has reduced its bond buying from $85 billion per month down to $55 billion per month. Conventional wisdom says that the reduction in bond buying from the Fed should have caused interest rates to rise. However, this just hasn’t happened yet.
As of this writing, the yield on the benchmark 10-Year Treasury Note is just above 2.7%. That metric is way down from the 2.99% level on Jan. 2. In percentage terms, that’s more than a 10% drop in yield — a move that’s left a lot of bond watchers scratching their heads in amazement.
So, why have rates been so low despite the Fed’s tapering?
A recent editorial in the Wall Street Journal by E.S. Browning does a good job of shedding some light on the issue, offering up sound reasoning as to why.
First off, the decline in interest rates this year is largely symptomatic of concerns about weak foreign economic growth, as well as sluggish economic data here at home. Tepid global and U.S. growth also has kept core inflation metrics below the Fed’s target of 2%. Yields are sensitive to inflation, and usually low inflation translates into low interest rates.
Second, there’s been strong demand for bonds this year, which Browning writes has come from institutions, pension funds and insurance companies that want to protect the stock market gains they’ve captured during the past couple of years. That likely has helped prompt a rotation away from equities and into bonds, and that demand has kept bond prices higher and bond yields down.
A third reason is the Fed itself, which consistently has pledged to keep interest rates low despite the taper. During the past several years, the smart money really has learned that fighting the Fed is a futile effort, so the theory here is that as long as the Fed has pledged to keep rates in check, that’s what is likely to happen.
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