Why bond bull market obituaries might be premature
The 35-year bond bull market has survived more than its fair share of premature obituaries. As Wall Street braces for a fixed income sell-off next year, don’t bet against it repeating the trick.
The consensus that higher bond yields are on the way is striking. A clear 76 percent of fund managers surveyed recently by Bank of America expect a steeper yield curve for long-term rates outpacing those for short-term debt. This is the highest level in the history of the investigation.
In a world where short-term interest rates are likely to stay close to zero for some time, a bet on a rising bond yield curve is actually a bet against longer-term bonds.
The case of a sale has an optimistic variant and a pessimistic variant. In the former case, growth is expected to pick up as Covid-19 vaccination programs allow economies to reopen in 2021. Along with rising inflation that comes with an erosion in the value of payment fixed interest bonds, this encourages investors to move away from low debt-producing bonds and into riskier assets. Meanwhile, governments continue to issue large amounts of new debt to fund their gaping deficits, driving down bond prices and driving up yields.
The darker version brings inflation back even if the strong economic rebound does not. In this scenario, central banks would be forced to consider curbing their massive bond-buying programs in an effort to keep prices in check.
The first problem with these narratives is that they are too US-centric. The US Treasury market has already started pricing them. The 10-year Treasury yield climbed to 0.95% from just over 0.5% in August, partly on hopes of further fiscal stimulus, further boosting bond supply. Inflation expectations have also rebounded sharply from the lows they hit at the height of the coronavirus crisis. But even the world’s largest bond market does not operate in isolation.
“The rates market is a global market,” said Robert Tipp, chief investment strategist at PGIM Fixed Income and skeptical of the opportunity for higher US yields. “People think the United States is the central market, but look around and it’s on the fringes. It’s a low-rate world and Treasury yields already seem too high.
Other major bond markets have largely ignored the recent rise in US yields. Inflation may flicker on the Federal Reserve’s radar screen, but it’s nowhere to be found in Japan or the Eurozone.
Japan’s central bank already has a policy of using purchases to fix borrowing costs at a predetermined level – something called yield curve control. The European Central Bank has also pledged to buy as much public debt as needed to preserve “favourable financing conditions” – in the oft-repeated words of Christine Lagarde, the bank’s president. For many investors, this sounds a lot like Japanese politics, minus the explicit return target. Germany’s 10-year borrowing cost is minus 0.58%, below levels seen this summer.
“You can’t make the U.S. curve steepen significantly relative to Europe,” said Steven Oh, global head of credit and fixed income at PineBridge Investments, who says most of the Treasury sale is already in the rearview mirror. shimmer. “The ECB is not going to let European rates rise at all. If the spread widens much further, European investors will start buying Treasuries. It maintains a ceiling on the height [US] returns can go.
Admittedly, the consensus does not call for another dramatic rise in yields. Analysts have forecast a 10-year Treasury yield of around 1.25% by the end of 2021 and 1.5% a year later, according to investment bank forecasts compiled by Bloomberg.
Even that may be overkill, unless inflation really comes back with a vengeance. Bond issuance alone is unlikely to drive up rates: there is little short-term correlation between government borrowing and yield levels. The three and a half decades of falling rates have coincided with a steady increase in public debt.
A rise in the monthly inflation figures is almost certain in the spring. Keep in mind that year-over-year rates will be measured against a period when demand collapsed and oil prices briefly turned negative. But the burden of proof lies with those who say there will be a prolonged bout of inflationary pressures. The world before the pandemic was certainly not one of a price spike. The Fed cut rates in 2019 in an effort to generate inflation while the ECB revived its bond-buying efforts.
Mr Tipp argues that the long-term forces weighing on inflation, such as the aging of the population and the sensitivity of indebted economies to a slight rise in rates, will remain in place even if Covid-19 has been defeated.
“We won’t be going back to Shangri-La,” he said. “Remember, in 2019 the Fed was talking about how to get inflation higher. This is a very positive environment for the bond market.
If he’s right, the big bond bull market will still have life.