Why 10-Year Treasury Yields Continue to Defy Conventional Wisdom

(Bloomberg View) -- The yield on the 10-year U.S. government bond continues to defy conventional market views. Instead of marching up to 3 percent, if not higher, as many expected, it fell this week to below 2.80 percent, its lowest level in almost two months. The reasons matter for a wide range of markets, as well as for policy thinking.

Increased risk aversion is the most-cited immediate explanation. According to this interpretation, the recent pickup in market volatility, together with two notable air pockets for stocks this year, is pushing investors out of stocks and to safe assets. Treasuries are the greatest beneficiaries of this flight to quality, which is a particularly important warning indicator for high-risk market segments that lack a sufficient depth of investor support.

Although this may account for some of the recent short-term moves in yields, it does not explain why rates have consistently undershot the majority of projections. Nor does it tell us why they have done so during periods of both higher and lower stock markets.

Another explanation is that bond markets are anticipating a notable slowdown in the U.S. economy. Others point to the failure of inflation to rise in a sustainable fashion, even as the economy continues its robust performance and unemployment is historically low.

Proponents of this view point to the more mixed data of recent weeks, both in the U.S. and in Europe, as well as the sharp decline in favorable economic surprises. This approach is often amplified by the notion that the less favorable economic outlook will restrain the Federal Reserve from hiking rates as much as it has signaled in its forward guidance (two more times this year).

But this explanation struggles to explain why a prolonged period of relatively low rates coincided earlier with stronger economic data and a series of favorable surprises. This belief also overlapped with some market participants' view that the Fed would hike even more than it had signaled.

Supply does not provide a fully satisfactory explanation, either. While many years of central bank buying have dramatically reduced the “free float” of government bonds, the issuance outlook has been revised considerably higher in response to recent fiscal actions in the U.S. and the higher deficit associated with them.

The best place to look for a persistent reason for the downward pressure on yields is a large Wall Street trading desk. I suspect traders would say that an important reason continues to be what I call non-commercial flows -- buying that is less sensitive to prevailing bond prices and is often poorly predicted by market participants. And it is not just about the monthly purchases by the Bank of Japan and the European Central Bank, as large as these have been. Also consider developments in pensions and other retirement and insurance-related flows.

These non-commercial flows are far from irrational. Indeed, they meet an important objective: reducing the probability of shortfalls in meeting future payment promises.

The impressive stock rally in 2017 reduced the average funding gap for pension funds in advanced countries, even as it bolstered the balance sheets of other providers of long-dated financial protection products such as life insurance. This, in turn, has increased both the willingness and ability to “immunize” future obligations. And the less risky way to do so is to match long-dated liabilities with safe long-dated assets.

It will take some time before such flows become a lot less important, but until then more standard explanations of yield behavior will continue to struggle to provide a full accounting of the past and present, as well as accurate predictions of the future.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He was chairman of the president's Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include "The Only Game in Town" and "When Markets Collide."

To contact the author of this story: Mohamed A. El-Erian at melerian@bloomberg.net.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.

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