The Outlook for Bonds

10Y US Treasury Yield 2

Prominent warnings of soaring bond yields, and therefore losses for investors who own bonds, have been pervasive since the end of the global financial crisis in 2009. Perhaps the most famous such prediction came from Nassim Nicholas Taleb, who in 2010 said, “It’s a no brainer, every single human should short U.S. Treasury bonds.” But these prognostications have so far proved wrong, as bond yields have actually fallen. The yield on 10-year Treasury bond is below 2%, not far from its all-time low set in 2012. So when will bond yields actually start to rise and bond investors start to feel the pain?

The first thing to note is that there’s no immutable law of economics saying that bond yields have to rise back to what historically have been more “normal” levels. In Japan, which has suffered a quarter-century of weak economic growth, the yield on the government’s 10-year bonds has been below 2% almost constantly since the late 1990’s. It’s now close to 0%.

That being said, it’s still more likely than not that US bond yields will rise, especially given their current levels. A major determinant of longer-term bond yields is what investors expect short-term interest rates (which are set by the Federal Reserve) to be in the future. Amid signs over the past year that the US economy is strengthening, the Fed has signaled that it will likely start raising interest rates in the middle of this year.

But even that’s no guarantee that bonds will suffer. If the Fed raises interest rates too quickly and causes the economy to lose steam, bond yields could actually fall as investors anticipate that the Fed will have to halt or even reverse its rate rises. For bonds yields to rise substantially, economic growth has to remain strong enough that the Fed feels the need to continue to raise interest rates.

Given the headwinds facing the economy that are beyond the Fed’s control, such as an aging population and a weak global economy, it’s possible that the Fed won’t end up raising interest rates very quickly or very far. While bond yields are likely to rise from where they are currently, they won’t necessarily reach what many consider to be historically “normal” levels. The predictions of soaring bond yields could prove just as wrong in the future as they have for the past 6 years.

Topics: Blog Bonds Interest Rates