Forecasts are for Long Term Bond Yields to Increase to 4 Percent to 5 Percent

For many years now, bond yields and interest rates have been at record lows. While rates and yields have moved higher from record lows, they are still not near historical norms. Current 10 year bond yields closed on Friday at 1.85 percent, down from a high of 2.02 percent on February 19. The best 5 year CD rates remained just below 2.00 percent this past week.

In four different forecasts, 10 year U.S. Treasury yields are expected to rise above 4.00 percent and possibly as high as 5.00 percent by 2017. With 10 year U.S. Treasury yields in that range, we can expect 5 year bank CD rates to move up to the 3 percent to 4 percent range as well. Shorter term CD rates will also increase but where rates are will depend on the inflation rate and where shorter term bond yields are in 2017.

In a speech on long term interest rates at the Annual Monetary/Macroeconomics Conference, the Federal Reserve Chairman, Ben Bernanke, spoke as to why long term bond yields are so low and where yields are headed in the future. The main reason why rates are at record lows is due to the central bank driving rates lower but there are other factors to consider.

The Chairman, said:

So, why are long-term interest rates currently so low? To help answer this question, it is useful to decompose longer-term yields into three components: one reflecting expected inflation over the term of the security; another capturing the expected path of short-term real, or inflation-adjusted, interest rates; and a residual component known as the term premium.

The first component, expected inflation, has been stable for many years now even though many inflation hawks warned of higher inflation due to the Federal Reserve’s policies. The Fed’s aggressive policies of keeping the fed funds rate at zero percent along with purchasing long-term bonds and mortgage-backed securities hasn’t caused inflation at all.

The Fed’s credibility for forecasting inflation correctly the past several years combined with their issuing statements about keeping the inflation rate under 2.00 percent has forced bond yields lower. The Fed has acknowledged in past statements that a negative side effect of a low fed funds rate and low bond yields are low rates on interest bearing assets.

The second component is the new openness of economic policy. The financial crisis brought more transparency from the Federal Reserve as investors needed reassurance of the future. The Federal Reserve’s communications over the past several years have pointed to keeping the fed funds rate very low for some time. For the first time, Federal Open Market Committee (FOMC) publicly stated they plan to keep the Fed funds rate in a targeted range until the unemployment rate falls to a certain level.

The FOMC stated they “expected to keep an exceptionally low level of the federal funds rate at least as long as the unemployment rate is above 6.5 percent, projected inflation between one and two years ahead is no more than a half percentage point above the Committee’s 2 percent target, and long-term inflation expectations remain stable”

The last component is term premium, which the Federal Reserve Chairman stated is the largest portion of the downward move in long-term rates. The term premium is the extra return investors expect to obtain from holding long-term bonds as opposed to holding and rolling over a sequence of short-term securities over the same period. Basically, the premium compensates bondholders for interest rate risk, the risk of capital gains and losses that interest rate changes imply for the value of longer-term bonds.

Ben Bernanke had the following comments about the term premium:

Two changes in the nature of this interest rate risk have probably contributed to a general downward movement of the term premium in recent years. First, the volatility of Treasury yields has declined, in part because short-term rates are pressed up against the zero lower bound and are expected to remain there for some time to come. Second, the correlation of bond prices and stock prices has become increasingly negative over time, implying that bonds have become more valuable as a hedge against risks from holding other assets.

The Federal Reserve’s purchasing large quantities of long term Treasuries and mortgage-backed securities has also lowered the term premium, which puts downward pressure on longer-term interest rates.

The Federal Reserve believes long term yields are headed higher in the future and has publicly stated so, which is a big departure from the past when no direction as to where rates were headed was provided. The FOMC believes rates will move higher because the economic recovery continues at a moderate pace, the unemployment will continue to slowly decline, and inflation is expected to remain near 2 percent.

All these factors will cause long-term interest rates to be expected to rise gradually toward more normal levels over the next several years. Higher interest rates are welcome news for holders of U.S. Treasuries, certificates of deposit, and all interest bearing assets. Following is a chart 10 year bond yields the past 13 years:

Forecasts are for Long Term Bond Yields to Increase to 4 Percent to 5 Percent

 

 
Author: Jason P. Jones
March 4th, 2013