William Bourne debates whether bond yields have at last reached their bottom
Bond yields have been falling for 42 years since they peaked in 1974 at over 15% and many a shirt has been lost by investors calling the bottom. However common sense tells us that this trend cannot be extrapolated forever and that buying a UK government bond today which pays 1% and matures in 31 years’ time is unlikely to be a good investment if held to maturity. For the privilege of receiving protection against inflation, investors have to fork out 1.6% over a similar period. Yet that is almost precisely what the purveyors of LDI, albeit with a few compensatory bells and whistles, are asking us to do. This article questions whether the time has come to call the bottom for bond yields.
The arguments made for ever lower yields depend on two main planks. The first is that central bank policy will remain unchanged. Even before the 2008/9 financial crisis, the ‘Greenspan put’ implied that if economies or markets ran into trouble the Federal Reserve would respond by printing money. Since then, of course, that has become orthodoxy throughout the Developed World with ever greater monetary printing and ever less effect on the economy. The latter is due to money simply pouring into asset purchases, whether banks buying government bonds or individuals buying property and art, instead of percolating through to the working economy where it is needed.
Despite the clear unsustainability of current monetary policy, bond bulls maintain that central banks will not change course. However, winds of change are blowing, with increasing political recognition that the current policy is unacceptable to the many people who do not own significant assets and are therefore not benefiting from today’s policy. In Japan Prime Minister Abe won because he is promising change, while in the UK Cameron lost the Brexit vote because he didn’t. Clinton may well feel the same sting.
So what might change look like? At the policy level, we will almost certainly see much more use of the fiscal lever, whether through an abandonment of ‘austerity’, tax cuts or increased infrastructure spending to make use of the ultra-low bond yields. Both in Japan and the UK, this is already being spoken about; however the economy to watch is China where some estimates suggest the budget deficit is already approaching 10%.
Using fiscal policy will put money directly into people’s pockets and that will eventually mean higher inflation expectations. In the very short term this is likely to happen anyway, given oil is now up over 50% from the beginning of the year and many other commodities have also risen. However, the fiscal wind will blow over many years and perhaps decades.
The second argument made for ever lower bond yields is that of demand. Regulators, aided and abetted by investment consultants, have practically obliged pension funds to purchase bonds almost regardless of price. Basel 3 and Solvency 2 have also led banks and insurers respectively to purchase government bonds in order to meet capital adequacy requirements.
It is unlikely that these regulatory pressures will change in the short term, though there is a growing recognition (viz. BHS, British Steel and the aggregate liabilities of UK private sector pension funds) that duration or inflation hedging may reduce risk but, at the end of the day, does not pay pensions.
However, there is one source of demand which may well flow in the other direction quite soon and that is flight capital. Around US$1.3 trillion has flowed into the ‘safe haven’ of G4 bond markets over the past 18 months from China, Russia and other Emerging Markets. The data shows these flows are now clearly reversing, as the Chinese economy starts to recover.
At ‘normal’ levels, the prime determinants of bond yields are inflation expectations and real yields. Today, with both at historically low levels, it is the third determinant, the ‘term premium’ (or the amount which investors are prepared to accept or pay for the certainty of a 10 year annuity as opposed to a one year annuity rolled over 10 times) that counts. Currently this stands at -150bps (ie. investors are prepared to pay 1.5% per annum for 10 years for the privilege of certainty of return).
What next? Well, we can expect two of these three fundamental determinants to move upwards. Fiscal easing will lead to higher inflation expectations, while the term premium is likely to rise to somewhere around its long term average of zero, driven by the reversal of ‘flight capital’ flows. On the other hand, there is unlikely to be a great change in real yields as there is too much free money around. With the US rolling towards recession the Federal Reserve is likely to print more money to ward it off. Regulators will only change their behaviour slowly but we can expect an increasing flow of ‘safe haven’ capital back into Emerging Market economies as they recover.
Putting all this together, it is not unreasonable to expect the US 10 year bond yield to move upwards by 1% to 2% over the next 12 months. That would lead to a yield of around 3%, a level last seen on 5th January 2014. However the real impact would be on behaviour. The cosy certainty that bond yields will fall ever lower will have been broken, and investors and their consultants may actually be required to put their thinking caps on again.