Long- term bonds turned in one of the best years in recent memory, an observation that is often drowned out by the cheers in the equity markets. Starting in January 2019, the U.S 30-year bond yield stood at 3%, steadily marched southward, reaching a low of 1.9% in August and finished the year at 2.3%. A similar drop in yields took place in Canada, as the 30-yr bond yield dropped from 2.2% in January to 1.7% at year-end. In the past, a drop in yields of this magnitude usually occurred as a result of a significant credit event where there was the fear of a systematic collapse in the debt markets; or, investors anticipate a significant slump in economic activity, as took place in 2001. No doubt, we could point to concerns over trade restrictions and weakness overseas, but these concerns have been around since 2016 when the Trump administration took office. Recessionary fears emerged mid-year when the yield curve inverted and there was no end of discussion as to the true meaning of an inverted yield curve in today’s financial environment.  Concerns over a possible slump dissipated by the fourth quarter, allowing for the equity markets to continue to climb. Yet, bond yields remain subdued and the slight in increase in yields late in the fourth quarter would hardly constitute a reversion to reflation. So, no one external factor could be cited as the reason for the steady decline in long term rates.

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Bond yields decline as expectations for future inflation fall, and this is the main reason behind the drop in yields in 2019. This shift in inflationary expectations can be traced back to the Federal Reserve policy actions in 2015-16. The Fed began to shift gears and initiated nine 25bps increases in its federal funds rate, a measure of the degree of tightening that did ultimately slowed down economic growth, altering the path of future inflation. However, policy shifts have a delayed reaction upon economic activity and the full impact was not felt until 6-9 months later. As expected, the restrictive monetary policy resulted in manufacturing contracting, car sales falling, and construction and housing prices sliding. The Fed then shifted geared, once again, and cut rates 3 times in 2019. All along, inflation remains below the Fed’s target and growth rates soften further.

Added to the Fed’s restrictive interest rate measures are the liquidity problems at home and abroad. Under the desire to shrink its balance, the Fed reduced world dollar liquidity. Worldwide, investors lowered expectations of inflation, with the result that government bond yields fell globally. Thus, it came as no surprise that record lows in long- term interest rates have been recorded in all major economic regions.

The Fed soon recognized that its policies were too restrictive and needed to re-institute its bond-buying program to ease liquidity concerns and promote expansion. But the Fed has not really opened the floodgates and, at present, the monetary expansion is relatively moderate given the recent history. Consequently, inflationary expectations remain below targets, set by central banks, and bond yields will likely remain around these levels or lower in the coming months.