Is the 35-year-old bond bull market over?
Or will the recent rise in yields prove to be just another blip as in 1994?
In 1979, US President Jimmy Carter gave Paul Volcker charge of the Federal Reserve because of his anti-inflation credentials. To tame US inflation that was running at 11% annualised on his appointment, Volcker raised the US cash rate by 9 percentage points to 20% within his first 12 months as chair. After the cash rate peaked at 21.5% in 1981 and triggered a recession, US inflation slowed to 5% by 1982 and was down to 3% soon after.
Bonds surged (yields fell) accordingly after Volcker acted because tame inflation is good for bonds as it preserves the value of future payments. The bond rally gathered pace over subsequent decades because other forces emerged to contain inflation, even when global economic growth was buoyant. Inflation targeting by independent central banks spread beyond the US (and Germany where it already existed), while globalisation helped create manufacturing hubs of cheap goods in China and elsewhere. In addition, higher debt loads and the ageing of the western world trimmed potential economic growth rates. Beyond these structural forces driving down inflation and growth, hence bond yields, in developed economies, key emerging and oil-producing countries invested their current-account surpluses in developed market bonds, and thus suppressed yields even more. Compounding these forces, since the global financial crisis, central-bank asset buying aimed to revive sluggish economic growth and ward off the spectre of deflation propelled the surge in bonds to record low yields. In much of Europe and Japan, these record lows, almost unbelievably, were negative numbers.
But yields are rising now, especially since the unexpected victory of Donald Trump in the US presidential election. US 10-year Treasury yields have jumped from their recent low of 1.36% on July 8 to 2.38% on November 30. Similarly, Australian 10-year bond yields have risen from 1.80% on August 2 to 2.86% at the end of last month.
Yields, to be sure, are still low by historic standards. Financial prices never move in straight lines and this is not the first time that bond yields have backed up since the early 1980s. Veteran bond investors recall that US 10-year government yields jumped about 250 basis points over 10 months in 1994 after the Fed unexpectedly raised rates to quell inflationary pressures. Yet the capital losses generated from this episode were recouped quickly for long-term holders because 1994 proved a cyclical blip and the bull market resumed from 1995.
The big question hovering over bond markets now is whether the recent drop in bond prices signals the end of the 35-year bond bull market – or is it just another brief disruption to the bond rally as occurred 22 years ago? While it’s too early to be definitive, the current move appears more cyclical than structural as most of the longer-term drivers of longer yields remain in place.
Mostly in place
The combination of the Trump fiscal expansion plans, which should boost short-run US growth and inflation, and an already moderately reflating global economy indicates that yields have further to rise. However, the structural drivers of the bond bull market are mostly still in place. Central banks still operate (CPI-based) inflation-targeting regimes, largely without political interference. Global excess labour supply, relative freedom of movement of global capital, open trade and technological advances continue to put downward pressure on the cost of manufacturing goods and (more recently) providing services. Potential growth remains weighed down by high debt loads and ageing populations.
However, in addition to the cyclical lift, one important driver of low bond yields does appear to be changing – a shift in emphasis from monetary to fiscal policy is likely underway. While this seems clear in the US (even though at this stage we’re not yet sure of the Fed response to Trumponomics), it’s also possible elsewhere as a pick-up in global activity and recognition by central banks of limits to unconventional policy support a gradual retreat from monetary accommodation and a refocus on fiscal expansion.
Does a switch from monetary to fiscal policy ensure higher yields in the long term? Not necessarily. For one thing, there are risks that fiscal stimulus drives an overshoot in US growth and that triggers a Fed response that ushers in an earlier-but-harder recession. Japan’s experience also shows us that fiscal policy, too, has limits in fighting powerful structural forces suppressing growth and inflation. Yields there quadrupled to 2% in 2006, but ultimately they were quashed back lower.
The low-yield difference
A central question for bond investors today is: what are the implications of today’s low yields? First, lower yields mean that there is a narrower income buffer against capital losses – so there is simply a greater likelihood that bonds will deliver total return losses over short periods (remembering, however, that a positive-yielding bond held to maturity will deliver a positive nominal return over that time frame). This is problematic for a defensive asset. Second, lower yields imply that a bond has less ability to rally further. This suggests that fixed income’s ability to diversify a portfolio may be curtailed to some extent. However, while the probability of losing money from a stand-alone bond investment might be high with yields low, it is worth remembering that the downside for bonds is much less than for equities.
Another risk at low yields is higher volatility, as bonds are more sensitive to yield changes at lower yields. To date, however, yield and return volatility has been low over recent years, though this could change. Longer-term investors shouldn’t care too much about volatility per se but investors need to be careful if bonds are a liquidity option in their portfolios. While government bond markets are likely big and deep enough to remain highly liquid, some credit markets might become less liquid.
Given all the worries about rising yields, investors should recall that they invested in fixed income for its defensive characteristics. Bonds protect investors against a sudden return to disinflation or deflation if economies crumble. They are still highly liquid, income-generating investments that won’t crash as equities can. While the defensive characteristics of bonds – capital stability, income generation, liquidity and diversification – are challenged to a degree by low yields, bonds still have enough defensive and diversification qualities to justify their inclusion in portfolios, even amid concerns that the Volcker-inspired bond bull rally is over.
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