Why Are Treasury Yields Falling?

Treasury yields have long been viewed as harbingers of economic growth, often with good reason. Rising yields and a steepening curve—the closely watched gap between short- and long-term rates—generally reflect optimism about growth, while falling yields and a flattening curve typically foreshadow a slowdown ahead.

So it’s not surprising that, as long-term interest rates have declined and the yield curve has flattened, many investors have begun anticipating slower growth than what was expected earlier this year. As of 4p.m. July 12, the 10-year Treasury yield, at 1.37%, was down 37 basis points, or hundredths of a percentage point, from its year-to-date high in March. The spread between 2-year and 30-year yields had declined 53 basis points in that time.

While some may anticipate a slowdown, we take a more sanguine view. Keep in mind that, even as long-term rates have declined, equity markets have been relatively stable and spreads between corporate and Treasury yields have remained tight, a positive sign. So, what’s really going on in the Treasury market? Rather than signaling a change in economic outcomes, we believe Treasuries have become disconnected from fundamental market conditions due to extreme technical factors that are keeping rates low. These include:

• Central-bank bond-buying: Continuing to buy $120 billion per month in Treasury bonds and mortgage-backed securities, the Federal Reserve owns a record 24% of the outstanding U.S. Treasury market, up from less than 15% prior to the pandemic, putting downward pressure on long-term rates.  

• Slower issuance: As government spending has slowed and tax receipts have picked up, Treasury issuance has also slowed, further depressing rates.

• Non-U.S. bond-buying: Investors outside the U.S. have recently stepped up their Treasury purchases, given favorable yields compared to even lower ones in other sovereign markets.

• Pension-fund rebalancing: In the wake of strong performance across major asset classes and the subsequent boost to funding levels, many pension funds have moved to “de-risk” more aggressively by shifting more of their assets into Treasuries.

Recent investor behavior in response to falling yields could pose risks. Perhaps misinterpreting the temporary drivers of low rates, investors have recently pumped up valuations of secular growth stocks, especially in technology sectors that account for a growing percentage of major indexes like the S&P 500. As a result, information-technology companies have seen their price-to-sales ratios rise to levels last seen at the peak of the 1999 tech bubble, despite facing headwinds ranging from higher input costs and a weaker dollar to higher taxes and stricter regulations.

Investors should watch for 10-year nominal Treasury rates to rebound toward 1.75% in this third quarter. Rather than chase tech stocks higher, we urge investors to focus on stock-picking, emphasizing earning fundamentals and free cash flow. The financials sector, in particular, stands out as a quality- and value-oriented hedge against rising rates. Recent dividend hikes, following the relaxation of capital restrictions, have contributed to attractive relative income as well.   

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 12, 2021, "Dancing 'Til the Music Stops." Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.