A 2% Ten-Year Treasury Yield? Once in 100 Years

A critical question facing investors over the next year and the next decade is whether the ten-year Treasury yield has fallen to the bottom of its long-term cycle. Yields in early October were at their lowest point since 1954, save for a brief plummet to 2.13 percent as the result of panic buying in early 2008. The ten-year has traded during October in a range of 2.3 to 2.7 percent.

In the past two months, some prominent economists have predicted that the yield will fall to 2 percent and possibly lower in the coming year. For example, according to a report by the rate division of Merrill Lynch Bank of America Corp. issued in early September, “Treasury 10-year note yields will drop to 2 percent in the first quarter of 2011 after the Federal Reserve expands its purchases of U.S. debt.” According to David Rosenberg, a high profile economist and for many years chief economist at Merrill Lynch, “The benchmark 10-year Treasury yield will drop below 2 percent over the next 12 months as US economic growth loses traction.” He further predicted the ten-year rate “may dip to as low as 1.5 percent if the economy deteriorates further.”

Deutsche Bank predicted as follows at the end of September:

Our rate forecast of 2 percent in the 10Y Treasury yield by the end of the year continues to be our view after the Fed’s statement that it was ‘prepared to provide additional accommodation if needed’. Chiefly, our rate view is based on the fundamentals of the economy. But the possible announcement of Q[quantitative] E[easing]2 in November creates the possibility of the market overshooting compared to our rate forecast, with 10Y yields moving substantially below 2.

Most mainstream economists do not share these views. In early September, Bloomberg reported that the average forecast of 72 analysts in its survey was that ten-year note yields would increase to 3.25 percent in the near term and 3.75 percent by year-end. If rates rise to those levels near term, the Federal Reserve’s new quantitative easing initiative will have been a dismal failure because it is meant to lower yields.

A look at the history of the ten-year rate provides some valuable insight into likely future trends. Based on data compiled by Yale University economist Robert Shiller and the Federal Reserve, the ten-year rate has fallen below 2 percent only once in the past 100 years. It fell to 1.95 percent in 1941. The rate peaked at 12.81 percent in 1981 and has been in overall decline for the past 30 years.

My view is that it is unlikely (less than 40 percent probability) that the rate will fall to 2 percent or less. In short, the nadir of this long term rate cycle has probably been reached. In part, this is because a 2 percent rate will be a psychological barrier and a tipping point at which key economic players will fundamentally alter their strategies.

Additional factors likely to preclude a rate lower than 2 percent in the coming year include:

• The economy is unlikely to fall into renewed recession. Growth, albeit slow growth, would be inconsistent with further decreases in Treasury rates.

• Lower Treasury rates have resulted in a lower dollar and higher commodity prices. The inflationary impact and potential of these events will curtail investment in long-term bonds.

• The Federal Reserve’s likely QE strategy will result in less benefit to long-term rates than the bond market currently anticipates.

Investors must adjust their fundamental long-term outlook on the markets. For over 30 years, rates on Treasuries have been falling. The expectation that rates will continue to fall is deeply embedded into investor expectations. Having lived in one investment environment for 30 years, it is difficult to adjust to a new outlook where rates no longer fall. The managers of PIMCO, the world’s largest bond fund, call this environment the “new normal.”

On a practical level bond prices are unlikely to increase and rates are unlikely to fall over the next few years. They may, however, remain relatively flat for a long period. According to Shiller’s study, the ten-year rate remained between 2 and 3 percent from 1935 to 1955 – an entire generation – save for the dip to 1.95 percent in 1941. The management of PIMCO suggests that the coming decade will be a period of low rates.