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.
Finally, there’s the technical picture in bonds that continues to show interest rates remain under pressure. According to Asbury Research, a firm which tracks a series of technical indicators that have proven spot-on in terms of interest-rate trends, recent buying patterns of commercial futures traders; the action in U.S. Treasury bonds vs. German government bonds; and also surveys of trader attitudes all indicate lower rates on the horizon.
The bottom line here is that despite the Fed’s tapering, there are other, more important drivers operating in the bond market.
As an investor, the low-yield conundrum should be viewed as an opportunity to make big gains in sectors that benefit most from the current situation. Bonds, precious metals and especially emerging markets are some of best ways to take advantage of the trends we’ve witnessed in rates. That is precisely what we are investing in with my Successful Investing advisory service.