OCEAN CITY — Bond yields have risen swiftly this month, with the 10-year U.S. Treasury having neared 2.5% from 2.12% at the end of May. The speed and magnitude of this move have caught most investors by surprise, just as they had become accustomed to the steady decline in yields over the past two years.
The current bond market selloff has triggered memories of the “Taper Tantrum” in the summer of 2013, when yields similarly spiked. However, we remain steadfast in our view that excess capacity in the global economy will keep interest rates below their historical averages for some time, and that bonds still play an integral role in diversifying portfolios. Some have attributed the recent rise in U.S. yields to a similar move in German Bunds. Whether this is correlation or causation, the fact remains that economic data in the past month has indicated that growth in developed markets is improving from the disappointing first quarter. As a result, inflation expectations are picking up and bond yields are rising.
In Europe, survey data indicating strength in the manufacturing and services industries was corroborated earlier this month by surprisingly strong retail sales growth. In Japan, GDP growth for the first quarter was revised higher to 3.9% annualized. At home, things are looking up as well. The jobs market is steadily improving, with a solid gain in payrolls and wages rising slowly but surely. Some of the concern that rising incomes have not translated into greater consumer spending has abated. Retail sales grew 1.2% for May, accompanied by the strongest month for auto sales in nearly 10 years (on a seasonally adjusted basis) and several signs that the housing market is rebounding after the winter pause.
As a result of the surprisingly positive economic data, inflation expectations have been steadily rising in both Europe and the U.S.. While economic activity may be improving, the pace of the recovery remains bogged down by muted demand and labor market slack. Inflation in the U.S. has stabilized, but remains below the 2% target of the Federal Reserve (Fed). In the eurozone, inflation remains much softer, but has picked up from a multi-decade low at the beginning of the year as the European Central Bank expanded its Quantitative Easing program.
The 10-year Treasury yield bottomed in 2012 at just under 1.4%, leading to a rising chorus calling for the end to the multi-decade bull market in bonds. While it’s true that bonds may not provide much capital appreciation going forward, they still remain an integral part of a balanced portfolio. We think that bond yields will remain below their historical averages for some time. Central banks abroad are still firmly committed to monetary stimulus, and we expect that low rates internationally will continue to pressure Treasury yields even as the Fed raises interest rates.
While yields on Treasuries are indeed low relative to history, they are much higher than those for most other developed market government bonds, and the recent uptick in yields does make them more attractive from an income perspective – especially compared to cash. Upcoming spikes in volatility may present good opportunities to deploy such cash flows.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)