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The worrisome thing taking place in bond market

Something worrisome is happening in the bond market.

Long-term Treasury bond yields fell Monday, with the 30-year bond yield hitting 2.682 percent, its lowest level since Nov. 9. The benchmark 10-year note yield, meanwhile, reached 2.121 percent, its lowest point since June 14.

Short and long-term rates have moved closer together lately, with the long end falling and the short end rising, as the Federal Reserve continues to raise rates while inflationary pressures on the U.S. economy have dissipated.

Movements like this—what bond market watchers call a flattening yield curve—can be an indicator there are concerns about the future pace of growth. Some other numbers are adding to the worries.

30-year yield 12-month chart

Source: FactSet

On June 14, the Labor Department said the consumer price index — a key measure of inflation — fell 0.1 percent in May, marking its largest drop in 16 months. Economists polled by Reuters expected a rise of 0.2 percent.

To boot, crude prices have been mired by concerns of oversupply. Last week, West Texas Intermediate futures dropped 3.8 percent.

Sean Darby, chief global equity strategist at Jefferies, said in a note Monday the 10-year yield should be moving alongside nominal GDP growth (real GDP plus inflation) around 4 percent. Instead, the 10-year is trailing nominal U.S. GDP growth, as it did in the 1990s.

Source: FactSet

“One of the rules of thumb when investing over long periods of time is that US 10 year treasury yields ought to run close to US nominal GDP (US real GDP plus inflation). As the chart [above] shows, it would appear that US long term rates are too low,” Darby said.

“While our base case is that the US and other G7 equity markets are benefiting from a ‘Disinflation Boom’ … similar to the late 1990s, ultimately monetary policy will tighten
enough to cause a recession,” he said, adding the Fed is facing the same “conundrum” it did when Alan Greenspan was the Fed Chairman.

The Fed has already raised rates twice this year and still expects to hike once more before year’s end.

“The bottom line is that the ‘disinflation boom’ will probably end as a combination of the US balance sheet beginning to be shrink combines with a slowdown in bond purchases by the [Bank of Japan] and [European Central Bank] through 2018,” Darby added.

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