Falling Interest Rates: Why?

Treasury bond yields have fallen over the last few weeks despite continuing improvement in U.S. economic data.  The relationship between the strength of the domestic economy and the direction of rates, which is generally positively correlated, has experienced a negative correlation in August likely because of global factors.  We learned last week that the Eurozone failed to produce any GDP growth in the second quarter, a worrying sign for the global economy.  Japan’s GDP fell nearly 7% in the second quarter due to a significant tax increase that went into effect recently, pulling spending forward to the early part of the year.  In addition, geopolitical tensions from the Middle East to Russia/Ukraine have created a "flight to safety" bid for U.S. Treasury bonds, which are thought to be the safest and most liquid assets in the world.  The question now becomes, can the U.S. economy continue its decoupling from the rest of the world and how will the Federal Reserve react to a stronger U.S. economic picture overlaid on a weaker global environment?  Given the fact that the majority of our economy is driven by service and consumer spending, we think that the recent domestic strength can continue.  The improving employment picture and stronger household balance sheets should lend support to consumer spending.  Inflation has likely bottomed and is approaching the Fed’s target levels.  These factors will likely lead to monetary policy normalization in mid-to-late 2015 and higher rates, which our portfolios are protected against.