How Higher Bond Yields Will Lead to Lower Yields

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Higher bond yields now will lead to lower bond yields later. That's what John Lonski, veteran bond market observer and chief economist at Moody's Capital Markets Research, argues in the  firm's latest Credit Markets Review and Outlook.

According to Lonski, recent economic problems in several emerging market countries "challenge forecasts" for 10-year Treasury yields to stay above 3%. "As long as the global economy operates below trend, the 10-year Treasury yield may not remain above 3% for long."

That's what has happened in the Treasury market recently. The 10-year Treasury yield which had consistently topped 3% since mid-month, closed below that level in the last two trading days before Memorial Day.

Higher bond yields have also led to a decline in the supply of corporate bonds, both high yield and investment grade, which eventually could also lead to lower yields in the bond market due to supply/demand considerations. A lower supply of bonds supports higher prices, and therefore lower yields since there is an inverse relationship between price and yield in the bond market.

According to Lonski, the supply of high yield corporates is down 16% versus a year ago as the average composite yield in that market jumped to 6.16%, up 25 basis points.

The supply drop was much more dramatic in the month of May. The average yield in the speculative bond market rose 63 basis points from the comparable yield a year ago and the supply plummeted 46% since then.

In the investment grade bond market, bond yields jumped 75 basis points in the first 22 days of the month, compared to the same period a year ago, to an average 4.06%, triggering a 31% decline in issuance.

Since 1988, the yield of the average10-year Treasury yield has fallen almost 30 basis points in the year after high yield bond issuance has declined, according to Lonski.

In the meantime, however, Treasury yields remain substantially higher compared to a year ago and that is weighing on the housing market, writes Lonski. Pending home sales in the first quarter fell at an annualized seasonally adjusted rate of 11.5% compared to the fourth quarter of last year and 3.7% before seasonal adjustment compared to a year ago.

"The recent record suggests that the 10-year Treasury yield  [which is the key level for 30-year fixed mortgage rates] will ultimately follow home sales," writes Lonski.

Since 1988 when the sum of new and existing single family home sales have fallen on an annual basis — which occurred in nine of those  years —   the median annual average yield of the 10-year Treasury yield fell 41 basis points.