Here's What's Really Driving Long-Term Treasury Yields

NEW YORK (TheStreet) -- Long-term government bond yields have been exceedingly volatile in recent months, and a driving factor has been global uncertainty. Investors have plowed their money into the perceived safe haven of government bonds when perceived risks rise, and then moved it elsewhere when they wane. 

Volatility should continue in the near future.

Take a look at the yield on the 10-year Treasury Inflation-Protected Securities, or TIPS. In the last week of December 2014, it was around 0.55%. In the first week of June, it was around 0.51%. In between, however, the yield dropped to around 0.02% at the end of January, rose back up to 0.42% on Feb. 17, fell again, to about 0.09% on March 24, and then dropped to less than zero in early April before rising throughout May.

Remember that Treasury yields move inversely to prices. When yields fall, it means prices -- and demand -- are rising. Those changes were closely associated with confidence in world markets. The focus is on these TIPS because yields on other Treasury securities move in a roughly parallel fashion to the changes in the TIPS.

For example, the yield on the regular 10-year Treasury security was about 2.30% at the end of December 2014, around 2.40% in the first week of June. The changes in the U.S. market were similar to those taking place in the yield on the 10-year German bund.

There's another source of demand for Treasury securities, however. Again, it's based on their safe-haven appeal amid global uncertainty, but in this case investors are keeping their money in Treasury securities over the long term and not moving it around as risks rise and then decline. Their demand keeps longer-term bond yields consistently below the levels they would rest at otherwise.

One sees the impact of these purchases by looking at Treasury yields, which tend to reflect expectations about what's going to happen to the U.S. economy.

Currently, the compound real rate of growth of the economy since the current economic recovery began is 2.3%. Obviously, the current yield on the 10-year TIPS being around 0.50% is substantially lower than the current rate of growth.

The forecasters in the Federal Reserve System do no expect the growth rate of the economy to be much different from the current pace, even though these economists are not predicting another recession over the next year or two.

If we assume that the growth expectations are around 2.5% and we adjust this downward to, say, 2.0%, the rate financial markets are comfortable with, this would mean that the yield on the 10-year TIPS should be 150 basis points higher than the yield that now exists in the bond markets.

Currently, financial markets have built in an expectation that inflation in the U.S. over the next 10 years should be around 1.9%. Adding theses inflationary expectations onto the expected real rate of growth of the economy, 2.0%, one can make the argument that the nominal yield on the 10-year Treasury security -- which doesn't enjoy the inflation protection that TIPS do --  should be around 3.9%, much higher than the current 2.4% level.

It's true that the Federal Reserve has pumped lots of reserves into the banking system over the past five years, but the central bank just doesn't have a great deal of influence over longer-term interest rates, particularly those of TIPS.

Instead, the reason for the low longer-term interest rates over the past few years has been the uncertainties that exist in world financial markets, uncertainties that have led to massive flows of funds into U.S. Treasury securities, both of the temporary and longer-term variety. It is this massive flow of funds that has resulted in the low, longer-term yields.

Thus, there's a crucial question investors need to ask themselves when they try to determine when longer-term yields on Treasury securities will rise: When, and under what circumstances, is the safe-haven money going to start moving back out of the U.S.?

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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