What Will Drive U.S. Treasury yields In 2014? Two words: The Fed

By Kira McCaffrey Brecht of Kitco News
Friday December 27, 2013 1:36 PM

(Kitco News) - In 2013, the benchmark 10-year note Treasury yield already saw a fairly sizeable increase from 1.69% in late December 2012, to an intraday high at 3.021% in late December 2013— its highest level since July 2011. And, that trend is likely to continue. Get ready for higher rates.

The main factors generally affecting the U.S. Treasury market are the overall U.S. economic outlook, the pace of GDP growth and inflation. But, in the wake of the 2008 global financial crisis, the U.S. Federal Reserve has been artificially manipulating and holding down U.S. rates, in an attempt to stimulate economic growth.

The U.S. has seen its longest run of historically low interest rates—at zero to 0.25% since December 2008 and the Fed has been aggressively buying Treasury and mortgage related securities in recent years. The Fed's balance sheet has soared from $850 billion before the financial crisis to nearly $4 trillion now, an unprecedented magnitude.

These factors have artificially pressured long and short-term interest rates in the U.S.

Now, the Fed is trying to let the cat out of the bag. Starting in January, the Fed will ease back on its monthly bond purchases—reducing it from $85 billion to $75 billion. Make no mistake, this is still a very accommodative monetary policy stance, yet it is the first signal on the road to eventual monetary policy normalization.

The U.S. economy is set to improve in 2014. Wells Fargo estimates a 2.4% GDP pace in 2014, versus an expected 1.7% pace in 2013. Credit Suisse forecasts a 2.6% U.S. real GDP rate in 2014. Inflation, however, remains below the Fed's target, with expectations for a 1.3% rate in 2014, according to Credit Suisse, and the Fed is seen reducing its monthly bond purchases to zero by the end of the year. What does this mean for 10-year Treasury yields?

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Ryan Sweet, director at Moody's Analytics forecasts that 10-year Treasury yields will push to a 3.65% rate by year-end 2014. Sweet expects the yield curve to widen "because the Fed will keep short-term rates rock bottom until the second half of 2015."

Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi, estimates the 10-year Treasury yield could climb to 3.25-3.50% by year-end. "It's a normalization of interest rates. They got down pretty low. Yields should adjust back to early 2011 levels. It is just a process of normalization," he said. See Figure 1 below for historical reference on 10-year yields.  

David Jones, president of DMJ Advisors LLB, and long-time Fed watcher with 35 years on Wall Street, agrees that higher yields will be seen in 2014. However, he warns there could be significant volatility on that path to higher rates. "Since the Fed drove long-term rates to artificially low levels, we have to expect financial market instability. In the process of moving rates up, we could see extreme volatility. It's hard to forecast the magnitude, but the instability will depend on how aggressive the Fed is with its tapering," he explained.

The Federal Reserve faces a major challenge ahead in unwinding its current monetary policy accommodation. This is a major unwind, which has never been done before. Communication to markets will be a critical element and there remain many boulders in the path. Currently, Fed watchers don't forecast an increase in the official federal funds rate in 2014. But, if economic growth were to surprise on the upside during the first and second quarter, the Fed's communication policies and exit strategy will face additional challenges.

"As we progress throughout the year, people will wonder how fast tapering will go and how fast they will raise interest rates. We think that [tightening] will happen in 2015, but if data comes in strong early in the year, people will start to price in Fed tightening earlier," said Jay Bryson, global economist at Wells Fargo.  If this scenario were to unfold, it would inject another dose of uncertainty and likely volatility into the U.S. interest rate market.

Then, there is the risk that unwinding the Fed policy could go bad. "There is the 'spike story'," said Bank of Tokyo-Mitsubishi's Rupkey. "That could occur if the Fed doesn't implement its exit strategy properly. There are people who have dire outcomes, with 10-year yields at 4-5%--they see a disastrous exit from the $4 trillion balance sheet," he added. That, however, is not Rupkey's expectation or forecast.

Another risk on the horizon is that the markets try to force the Fed's hand. "If the markets feel that they’ve left rates at zero for too long, that could send the 10-year Treasury above 3.5%. If the market feels the Fed has gotten behind the curve and it's time to start normalizing rates it could push 10-year Treasuries higher," explained Rupkey.

There are other factors, as well that have the potential to significantly impact long-term yields in 2014. Moody's Analytics Sweet points to the U.S. economic growth, inflation and Fed policy as big issues for the bond market, but he also warns that "political brinkmanship" has the potential to push up 10-year Treasury yields. "The debt ceiling hasn't been resolved," he warned.

The timing of when a debt ceiling "crisis" could hit again in 2014 is somewhat uncertain due to the special measures the Treasury can utilize to pay the government's bills. However, for now, Moody's Sweet expects that U.S. policy makers could choose to avert another crisis or shutdown. "Our assumption is that they don't want to go down the same road that they did in 2013. We think they will raise the debt ceiling without any battle," he said.

Another aspect to consider is the appetite of foreign buyers for U.S. Treasury bonds in 2014. John Lonski, chief financial markets economist at Moody's Analytics, points back to the 2004-2006 time period. "The Fed was hiking the fed funds rate, but the 10-year was not moving higher in lockstep. The problem was that China was buying up U.S. Treasury bonds," Lonski said.

This time, while it may not be China stepping up at the U.S. Treasury auctions, there is speculation that the Japanese could be eager buyers of U.S. debt in 2014. Looking at the comparative landscape, U.S. 10-year yields stood at 2.996% on December 27, versus a 0.711% for 10-year Japanese government bonds. As Japanese institutions and retail money searches for yield in 2014, there has been speculation that there could be a rotation toward U.S. debt. "I wouldn't be surprised if Japanese investors start buying," said Lonski.

If that were to occur, that could be a moderating influence on how much 10-year Treasuries were to rise.

Bottom line? The path toward higher yields appears set. A long-term bottom has likely been marked on the monthly 10-year yield chart seen below and rising rates are seen ahead. The only question is how fast and how far. Some volatility is likely along the way.


Kira Brecht is managing editor at TraderPlanet.

By Kira Brecht, Kitco.com
Follow her on Twitter @KiraBrecht

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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