this is the end

Last week, the US Treasury market suffered its worst losing streak since 2006. This rapid rise in yields has prompted investors to wonder whether the 30 year rally in bonds is finally coming to an end, and if so, how high will rates rise? The answer, it turns out, may surprise you.

First, some background: Despite record deficits and last year’s downgrade of the United States, the US Treasury market has benefited from a number of tailwinds: the reserve currency status of the US dollar, lingering aversion to equities, weak growth, and a private sector deleveraging that has resulted in a dearth of long-dated bonds.

Yet, even when you take all this into account, Treasury yields appear too low. Late last year, the yield on the 10-year Treasury dipped below the level of core inflation for the first time since 1980. By virtually every measure, including the TIPS market, real rates are negative. In contrast, over the past 50 years Treasury yields have typically paid roughly 2.50% to 3.00% above the prevailing rate of inflation. Furthermore, today’s negative yields also appear to defy economic logic: until recently, bonds were getting more expensive at the same time as a record build-up in US debt and a downgrade of US credit worthiness.

Part of the explanation for today’s paltry yields is that the recovery is weak and demand for capital low. However, weak growth only indicates that real yields should be low, not negative. Based on the historical relationship between economic growth and real yields, the yield on the 10-year Treasury is 1% to 1.5% below “fair value.”

Perhaps the real explanation is that today, the marginal buyer of a US Treasury is not motivated by the rate of return. My colleague Antti Petajisto in the iShares Investment Research Group has done some interesting research that shows that over the past 14 months, the dominant buyers of long-dated US Treasuries have not been private investors, but pubic institutions. In 2011, the Federal Reserve and the foreign public sector purchased Treasuries with maturities of at least 5 years in an amount that was greater than the total supply issued during the same timeframe. . In other words, private investors were net sellers.

Given this state of affairs, whether the US Treasury market is in a bubble or not becomes a much more difficult question. While rates offer poor return for investors, the market can remain high for a prolonged period if the marginal buyers are not investors but official institutions, particularly to the extent that at least one of them – the Fed – has unlimited resources.

That said, assuming the US economy continues to stabilize and there is no next incarnation of the Fed’s various asset purchase programs, we would expect that the yield on 10-year Treasury bonds continues to drift higher toward the 3% to 3.5% range, roughly where yields were during the first half of 2011. After that, the outlook will depend on a number of factors including inflation, whether China continues to diversify away from Treasuries, and how economic actors – not policymakers – view the inherent value of the instruments.