12-31-17 7:14 AM EST | Email Article
By Sam Goldfarb 

As the year changes, U.S. government bonds are still sending out cautionary signals.

While other assets have soared in 2017, yields on longer-term U.S. Treasury bonds have remained stubbornly low, suggesting little conviction among bond investors that a lengthy span of modest economic growth and paltry wage gains is on the verge of changing.

For most of 2017, the yield on the benchmark 10-year Treasury note fluctuated in a narrow band between 2.2% and 2.4%. One of the few times it broke through the upper end of that range was in late December, as Congress passed a major tax cut package.

By year-end, however, the yield on the benchmark 10-year Treasury note was back at 2.409%, just below 2.446% at the end of 2016 and below its March peak of 2.609%. Its premium relative to the yield on the two-year Treasury note -- a closely watched barometer of economic optimism -- was down to 0.522 percentage point, less than half its level from a year earlier.

Yields, which rise when bond prices fall, are linked to economic expectations, in part because a growing economy typically leads to lower unemployment, higher wages for workers and broader inflation, which is a main threat to long-term government bonds because it chips away at the purchasing power of their fixed payments.

Low Treasury yields have generally been good for investors in recent years, bringing down borrowing costs for individuals and businesses and bolstering stocks by making them look more attractive to yield-seeking investors. Still, if bond investors' lukewarm take on the economy is borne out, that could spell trouble for the furious rally in riskier assets that has propelled stocks to a string of records and pushed junk-bond yields to multiyear lows.

When it comes to the outlook for the economy and interest-rate policy, "there's a disconnect in terms of what the Fed is saying about rates versus what the market is saying," said James Sarni, a bond manager with Payden & Rygel. "While inflation is likely to inch up, it will be lower than people expect it to be."

Many bond investors and analysts say they have only modest expectations for the impact of the tax cuts coming out of Congress, in part because they deliver much of their benefits to corporations and wealthy individuals who are seen as less likely to spend extra cash than lower-income families.

While businesses could conceivably use money they get from tax cuts to give their workers additional pay, "the body of data for that is basically nonexistent," said Krishna Memani, chief investment officer at OppenheimerFunds.

Feeding bond investors' skepticism is the fact that the U.S. unemployment rate, at 4.1%, is extremely low, yet wage growth and inflation have been sluggish. That raises questions about whether the traditional relationship between unemployment and inflation may not be as tight as it once was, due to changes in technology and an increasingly globalized economy.

A range of studies suggests that the GOP legislation could add some fraction of a percent to annual gross domestic product over the next few years.

That would speed up the U.S. economy when it is already showing signs of faster growth, having expanded 3.2% in the third quarter.

Still, those estimates are uncertain and ultimately "don't mean a whole lot" when measured against the high hopes that investors previously had when they weren't anticipating only tax cuts but also a massive increase in fiscal spending on things like infrastructure, said Blake Gwinn, U.S. rates strategist at Natwest Markets.

The timing of the tax cuts also could work against them. Arriving more than eight years into an economic expansion, their impact could be mitigated by the Fed, which has begun to remove its support for the economy.

Having raised rates three times in 2017 and strongly signaling that it will raise rates three more times in 2018, the central bank has convinced most investors that it is committed to its tightening campaign, a change from 12 months ago when many assumed it was content to raise rates once a year at most.

Even if tax cuts can stoke inflation, many investors believe the Fed will try to stamp it out by taking an even harder line on rate increases.

That expectation has helped push up yields on short-term bonds, like the two-year note, which are especially sensitive to changes in monetary policy, but kept a lid on longer-term yields, which are more reactive to inflation expectations.

--Daniel Kruger contributed to this article.

Write to Sam Goldfarb at sam.goldfarb@wsj.com

 

(END) Dow Jones Newswires

December 31, 2017 07:14 ET (12:14 GMT)

Copyright (c) 2017 Dow Jones & Company, Inc.
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