As we approach the mid-point of the year many casual investors are surprised to look in on the market and find that bond yields remain stubbornly low. In fact, they have actually fallen during the year with the 10 year US Treasury declining from 3.03% at the end of December to 2.63% as of June 9th. And it turns out that this overall decline in yields has occurred across global bond markets. There are a lot of drivers of lower yields, including the continued accommodative policies of central banks and the continued slow growth in GDP and inflation in most developed economies. All of this comes together in net bond demand, which is how much demand there is for bonds relative to supply. The Fed’s QE program has been a big part of this, as it has created additional demand and has helped to push interest rates down. Today I wanted to take a closer look at the broader supply/demand picture.

A recent JP Morgan report noted an interesting statistic: in 2013 the new global bond supply was $200b more than demand. The data came from the Federal Reserve’s quarterly Flow of Funds report. The report’s observation was that this excess supply coincided with higher global interest rates in 2013. The same relationship played out in reverse in 2011 and 2012, in both years demand was greater than supply and in both years global interest rates fell. This relationship is fairly intuitive. When demand exceeds supply in any market, prices are driven up. In fixed income this means that prices are pushed up and yields are pushed down. The same mechanic plays out in reverse when supply exceeds demand. Prices fall, and for bonds falling prices result in higher yields.

This insight helps explain the 2014 bond market. In Q1 2014 supply was insufficient to keep up with demand, and the report estimates that for all of 2014 demand will outstrip supply to the tune of $460 billion. There have been many drivers of the year-to-date buying including retail investors, banks, and foreign entities. We’ve seen this trend in fixed income ETF flows with $18b coming into funds globally as of last month. Obviously these trends may not continue in the way the projection describes, but this imbalance does go a long way towards explaining why interest rates have fallen so far in 2014.

So what does this mean for investors?

  • The demand we have seen for fixed income this year is a significant contributor to lower interest rates. The demand is coming from retail investors through mutual funds and ETFs, as well as institutions and government bodies like the Fed.
  • Changes in this supply/demand picture will go a long way towards determining where rates go, especially shifts by central banks. The Fed is now midway through their tapering down of Treasury and MBS purchases, and our expectation is that they will have ended the program by the end of the year. This is in contrast to Japan, which continues their asset purchase program, and the ECB, which stepped up last week to increase liquidity and may be moving towards a form of QE. Even when the Fed is out of the picture, continued strong bond demand from foreign central banks and investors could keep rates in a low range. We believe that the 10 year US Treasury will likely move towards 3% by year end, but it’s doubtful that it will rise significantly above that level. The supply/demand picture just doesn’t make this likely. Yes the Fed will continue to taper, but other investors are expected to step in and fill the gap. The Fed isn’t the only bond player in town.
Related Articles
  1. Savings

    Become Your Own Financial Advisor

    If you have some financial know-how, you don’t have to hire someone to advise you on investments. This tutorial will help you set goals – and get started.
  2. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  3. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  4. Mutual Funds & ETFs

    Top 4 Investment Grade Corporate Bonds ETFs

    Discover detailed analysis and information about some of the top exchange-traded funds (ETFs) that offer exposure to the investment-grade corporate bond market.
  5. Economics

    What's the 1913 Federal Reserve Act?

    The 1913 Federal Reserve Act was a pivotal congressional act that helped establish the Federal Reserve System as it exists today. It is one of the United States financial system’s most influential ...
  6. Investing News

    Could a Rate Hike Send Stocks Higher?

    A rate hike would certainly alter the investment scene, but would it be for the better or worse?
  7. Economics

    Open Market Operations vs. Quantitative Easing

    How does the Fed's implementation of Quantitative Easing differ from its more conventional open market operations?
  8. Mutual Funds & ETFs

    Trading Mutual Funds For Beginners

    Learn about the basics of trading and investing in mutual funds. Understand how the fees charged by mutual funds can impact the performance of an investment.
  9. Professionals

    Will Interest Rates Rise at the Next Fed Meeting?

    Everyone wants to know what the Federal Reserve will do next, but the Fed doesn't even know what it's next move will be.
  10. Investing Basics

    The 4 Biggest Bond Myths

    Bonds can be a great addition to a portfolio but be aware of these four myths.
  1. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  2. Are high yield bonds a good investment?

    Bonds are rated according to their risk of default by independent credit rating agencies such as Moody's, Standard & ... Read Full Answer >>
  3. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>
  4. How is the Federal Reserve audited?

    Contrary to conventional wisdom, the Federal Reserve is extensively audited. Politicians on the left and right of a populist ... Read Full Answer >>
  5. Who decides when to print money in the US?

    The U.S. Treasury decides to print money in the United States as it owns and operates printing presses. However, the Federal ... Read Full Answer >>
  6. Why do some people claim the Federal Reserve is unconstitutional?

    The U.S. Constitution does not mention the need for a central bank, nor does it explicitly grant the government the power ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!