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Commentary: Falling Bond Yields: Not To Worry


What's up with the bond market? As the Federal Reserve has steadily increased short-term interest rates over the past few months, investors in the bond-trading pits have pushed long-term yields down. Indeed, the yield on the Treasury's 10-year note eased to 3.98% on Sept. 22, its lowest point in nearly six months, a day after the Fed bumped up short rates another quarter percentage point.

For the doom-and-gloomers, the answer to the bond market's seemingly perverse behavior is simple: Fears are growing that the economy is in for weaker growth than Fed Chairman Alan Greenspan and his colleagues think. "The market is skeptical of the Fed's forecast of a robust rebound," says Craig Coats, executive vice-president at investment bank Keefe, Bruyette & Woods Inc.

But wait a minute. Despite the naysayers' claims, the fall in bond yields is more a cause for comfort than concern. It mainly reflects ebbing inflation fears and growing investor confidence in the Fed's determination to keep price pressures in check, rather than worries about weakening gross domestic product growth.

That bodes well for the economy. As long as investors are convinced that inflation will stay low, the Fed can afford to take its time raising rates to more normal levels, giving the economy time to adjust.

Look at the numbers. After rising at an annualized 5.1% in the first five months of 2004, consumer price inflation slowed dramatically over the summer, to a mere 1.3%. Not surprisingly, bond yields fell in response. In fact, the 10-year Treasury note yield hit its high for the year, 4.87%, on June 14, the day before the Labor Dept. reported a dip in underlying inflation, and has been falling ever since.

End of a Scare

Inflation expectations have also eased, dragging bond yields down with them. Judging by the Treasury's inflation-protected securities market, investors expect inflation to average about 2.3% per year over the next 10 years. That's down from a 2.8% rate expected in the spring, at the height of the market's inflation scare. The implication: More than half of the drop in yields can be attributed to changing inflation expectations.

What's behind the pullback in inflation? The twin factors of competition and productivity. While productivity growth has fallen from its stratospheric levels of 2003, it is still on track to grow about 4% this year. That pace enables companies to hold the line on prices without seeing their profits get whacked. In fact, Standard & Poor's says that operating earnings of the S&P 500 rose 31% in the second quarter from a year earlier and are on track to rise 15% in the third quarter.

Investor Calm

It's no wonder, then, that the stock market has been on the rise since early August. Although share prices slumped on Sept. 22 after oil prices jumped and FedEx Corp. (FDX) warned that profits would fall short of expectations, key market indices are still trading near two-month highs. That suggests stock investors, at least, don't share the concerns of the economic worrywarts. "I don't think the economy is tanking, and I don't think the market thinks so either," says Nariman Behravesh, chief economist at consultants Global Insight Inc.

The story is much the same in the corporate bond market. If investors thought the economy was about to stall, they'd demand a bigger premium for corporate bonds vs. Treasuries to compensate for the extra risk of holding those securities. That hasn't happened. Instead, the yield spread between corporate bonds and Treasury securities has held steady as the debt market as a whole has rallied.

Part of that rally, especially recently, has been inspired by a short squeeze on bond market bears rather than by a change in the economic outlook. Many investment managers shied away from bonds early in the year, convinced that yields would rise as the Fed hiked short-term rates. Now, with the end of the year in sight, they're finding that they have to reenter the market to buy bonds in order to recalibrate their portfolios. Such buying is pushing prices up and yields down.

It's not always easy to parse bond-market behavior. There are millions of investors in the market. Undoubtedly, some of them are purchasing bonds because they're worried about the economic outlook. But the bulk of the buying so far has been for more benign reasons. The low interest rates it has brought should be welcomed, not dreaded.

By Rich Miller and Peter Coy


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