Bond yields have failed to rise in line with expectations. Taking a long-term view it’s not hard to see why.
To get the sort of bond yields that many commentators think we should have requires global nominal growth to reverse its long-term trend and move significantly higher. Quantitative easing has failed to deliver. China is growing at half the rate of a few years ago and populism is not going to provide the growth and jobs that its demagogic mouth-pieces would have voters believe. The best course of action is to downplay expectations of a massive rise in bond yields and think about what fixed income markets can offer you today. That is, as always, capital preservation, a source of income, total return opportunities and diversification against the promises of equity driven growth. Bonds can be an investor’s best friend.
The bond conundrum
Why are bond yields (still) so low? Since the Federal Reserve (Fed) initiated the current monetary tightening cycle in December 2015, long-term US bond yields are more or less unchanged. Since the most recent Fed rate increase, in March 2017, the 10-year US Treasury yield has fallen by 28 basis points (bps). Why haven’t bond yields – which represent the long-term cost of borrowing – gone up? Maybe the more appropriate question is why is nominal GDP growth (still) so low? The relationship between global long-term bond yields and nominal GDP growth is a fundamental one. Investing in (credit-risk free) government bonds should mean you get a return that is close to the rate of growth of the economy in nominal terms. If you didn’t then you would commit more money to corporate bonds or other risky assets in order to get a return closer to GDP growth. If you earned more from government bonds than GDP growth, everyone would buy government bonds, forcing the price up and the yield down. The relationship is not a tight one all the time, but for anyone with a long-term investment horizon, looking at the chart of long-term yields against nominal GDP growth answers most questions about why bond yields are still low. The approximate level of bond yields and the direction of change over time is related to long-term economic growth rates.
Long-term trend, but hardly reversing
The chart shows that the rate of nominal GDP growth and the level of US bond yields (the red line) have moved lower over the last 30-years. In the last decade we have been living in a sub-4% world. More recently, Japanese and European bond yields have been significantly lower than developed economies nominal GDP growth reflecting factors such as high savings rates, relatively lower inflation rates and financial repression policies in the form of quantitative easing (QE). The improved macro trend of the last year or so suggests a bottoming out in the growth rate of nominal GDP growth and the consequent bottoming of bond yields. Indeed, the consensus view is that yields are “too” low and that the tendency should be for them to rise. But by how much and driven by what? Sure, short term considerations about synchronised global growth, the potential for fiscal stimulus in the US, the Fed’s tightening plans and higher headline inflation all point to higher yields. However, if the longer-term trend is not towards higher rates of nominal growth, then the extent to which yields will rise is likely to be limited. This is important for bond investing. In the great moderation after the early 1980s, bond returns were much stronger than yields would have indicated given the unexpected and sustained decline in nominal GDP growth – led mostly by lower inflation rates. The 5-year rolling total return from US Treasuries was between 10% and 15% in the 1980s and was between 5% and 10% for the following 20-odd years. Now yields are low and appeared to have bottomed so what is the next secular trend? To get anything like a reversal of the great moderation then nominal growth would need to continually surprise to the upside, generating a long-period of global monetary tightening and higher interest rates. That seems somewhat unlikely at this stage. If it happened, bond returns would be negative for a while until coupons started to offset the potential capital loss from even higher yields. Safe to say the odds on this scenario are extremely wide in my opinion. A more likely scenario is that bond yields remain relatively low as nominal GDP growth remains low. More on how you should position in the bond market in this kind of environment.
It’s growth and inflation, stupid
So the real question should be why is nominal GDP growth (still) so weak? This can be disaggregated further into why is real growth so low and why has inflation not picked up even after many years of monetary expansionism? My “serious” economist days are behind me and there are lots of better qualified people who spend all their lives thinking about these questions and who may have much more rounded explanations, but I have my thoughts. On one side there is the impact of all the factors that have impacted and continue to impact on supply side fundamentals – new technology changing the production costs curve, disrupting the demand for labour, making things better quality for the same price. On the demand side are demographics, the drag of three decades of rising global debt and the fact that supply side dynamics often lead to lower real compensation for workers that are displaced. Not even the brightest economists understand the interaction of all these factors nor can they explain why the policy prognosis of the last decade has failed to deliver. It could have been much worse, but QE has not delivered the rise in inflation that monetarist economists of earlier ages would have forecast. Fiscal policy has been hamstrung by the debt levels that were generated during previous decades. No-one seems to understand supply side dynamics sufficiently to come up with radical enough policy proposals to really unleash the productive potential of labour or capital. Should corporate tax rates in the US be cut to 15%? Should the UK Labour party really be promising higher taxes across the board? Should the European Union reform its regulatory framework?
Reality is not meeting expectations
In the short-run the biggest bet on higher nominal GDP growth was on a potential fiscal boost in the US following the election of Donald Trump, coincident with the global recovery in economic activity that reflects a stabilisation in China and a long-awaited improvement in Europe. So far, none of this has added up to a strong enough recovery in global, nominal GDP growth or a factoring in of higher long-term risk premiums. So absent the boost to aggregate demand from a corporate tax reform and spending increase in the United States, what will boost nominal GDP growth in the major economies to levels last seen before the financial crisis? Until something comes along, bond yields will not rise very much. On the inflation side, which in the short run could have been a catalyst for higher yields, nothing much is going on. Headline rates have risen but that has largely been because of higher energy prices impacting on consumer prices. Core inflation remains stubbornly below the levels that central banks are targeting over the medium term. I was at an investor conference in Dublin last week at which the Chicago Federal Reserve President, Charles Evans, was speaking. He said that he just did not think it would be the right thing to do to accelerate monetary tightening (beyond some kind of normalisation of interest rates) until the Fed had at least hit its target for the personal consumption deflator rate of inflation. It hasn’t yet. In the bond market, break-even inflation rates may have moved away from pricing in deflation but they do not convince me that inflation expectations are on the move much higher.
Sentiment goes both ways
In the short term we can all see the arguments for higher interest rates and bond yields. Rates are too low relative to global growth and central banks are being too slow in moving away from emergency monetary policy settings. When they do make the policy shift, higher short-term rates and the reversal of balance sheet policies must surely lead to higher yields? Moreover, bonds are expensive relative to underlying economic conditions (especially in ongoing QE economies) and relative to equities in many markets where the dividend yield is much higher than the real yield in fixed income. With each twist and turn of the flow of economic data and policy, there is often a short-term case for higher bond yields and, of course, from a pure buy and hold point of view, the current level of bond yields does not suggest very exciting total returns. Much of the European and Japanese bond market trades with negative yields to redemption, meaning if you buy bonds now and hold until maturity you will lose money. Unless your mindset is that everything would deliver an even larger negative return, then it is a reasonable question to ask why would you invest in bonds? However, at the same time, sentiment is hardly euphoric. This week’s news from the United States has not been encouraging in terms of a strong Administration putting in policies that will lead to a new surge in supply and demand side momentum. Confidence in the “Trump Boom” has all but gone. As such, higher growth expectations are less justified than they were. On the risk side, there are ongoing political uncertainties around the UK, German and Italian elections. Recently, Chinese hard landing concerns have also re-emerged along with a reminder that emerging market economies remain prone to corruption scandals that can scare investors away. The ongoing proliferation of things for people to worry about means that investors are going to want to retain a significant weight to assets that provide a relatively higher level of capital protection. And for those that believe in the predictive power of the yield curve, the fact remains that term premiums remain extremely low.
Even with Fed Funds at 3%, how high do Treasury yields really go?
Perhaps the main reason for expecting higher yields, at least in the US, is that the Fed will keep on raising interest rates. The Fed’s dot plot has the Fed Funds rate at 3% by the end of this tightening cycle. In the past five tightening cycles, the 10-year Treasury yield has been – on average – just 0.3% higher than the peak Fed Funds rate at the peak of the cycle. If that pattern was repeated it would mean a 10-year Treasury yield of 3.3% at the end of 2018. That is just 110 bps above today’s level. I say “just”. It is still worth a trade to be short duration if yields are going to rise that much (better a 2% capital loss at the short end of the curve than a 10% loss in the 10-year area). But it means we shouldn’t be that bearish on bonds unless there are reasons to believe that the Fed will be more aggressive – and that goes back to the arguments about growth and inflation. Given the strong performance of global equities and the riskier parts of the bond market so far this year, it is my view that the arguments that underpin continued bullishness here will become much harder to sustain than those that suggest a new bond bear market is upon us. Even though bond yields remain low, there is a role for duration in a multi-asset investment portfolio as the price action between bonds and equities remains – particularly in stressed markets – a negative one. Long duration bonds can themselves be volatile but the combination with equities in a diversified portfolio produces a return profile that is much smoother than one for a pure equity portfolio alone. Over the last 10 years, a broad UK equity portfolio would have had a volatility of around 17% (using weekly return data). Switch 25% of that portfolio into long gilts and the volatility would have come down to 12%. Go half and half and the original equity volatility would have been halved. If the equity market rolls over because of more and more signs of us being very late in the business cycle, then bonds will perform.
Still a great asset class
Diversification of risk in a multi-asset portfolio is a core reason for still being involved in the bond market even with yields (still) so low. There are other reasons. Bonds offer relative capital preservation and for investors that do fear rising yields then a short duration strategy could work well given a modest income stream and lower volatility than a full market exposure. Income too is a reason to look to the bond market although yield levels constrain the level of income flow. Diversified credit exposure can still generate reasonable income especially when credit fundamentals continue to be supportive. Finally, the diversification offered by the fixed income markets means that they are fertile grounds for total return strategies. This year alone, taking a broad universe of fixed income sub-asset classes, total returns have ranged from -1.5% for European inflation linked bonds to +5.9% for hard currency emerging market debt. The relative performance of different parts of the bond market is driven by macro trends and that means there are always relative value and performance opportunities if a bond exposure is diversified and actively managed. Yields may stay low but you can still make money in fixed income.
Chris Iggo - CIO Fixed Income - AXA Investment ManagersBLOG COMMENTS POWERED BY DISQUS