Daniel Ben-Ami charts the downward path of bond yields over the last 30 years. While the widely anticipated end to this bull market may be imminent, the trajectory is uncertain
At a glance
• Discussions on the fixed income markets often suffer from short-termism.
• Experts argue that several forces pushed real bond yields on a long downward trend from the early 1980s onwards.
• This secular fall in yields is usually attributed to a combination of factors including the anti-inflationary policies of central banks, ageing populations, the extension of the global labour market and excess savings in some countries.
• The upward path in yields is likely to be long and drawn out.
• The main reason yields are expected to stay long for a prolonged period is because of what some experts refer to as secular stagnation in the West.
Discussions on the fixed income markets all too often have two weaknesses. They tend to be excessively short-termist and they wrench the discussion of bonds out of its broader economic context.
The first flaw is understandable but no less misleading. There is such an obsession with interest rate decisions that every pronouncement by central bankers and every new piece of data is scrutinised.
Of course central bankers never say outright how they will decide to move interest rates at their next meeting. So it becomes a matter of trying to decipher the tiniest nuance of their speeches. It has reached the point where it seems that analysts will even endow the raising of an eyebrow by a central banker with meaning.
The preoccupation with data releases is in line with the focus on central bankers. One day a relatively strong piece of data is said to raise the chance that rates will rise. The next day more downbeat data, or perhaps a development abroad, is said to increase probability that rates will remain unchanged. Assessments change from day to day, or even hour to hour, but little useful comes from the discussion. Nothing much might change in a typical week but there is endless to-and-fro speculation about likely rate movements.
Alongside this short-termism is a reluctance to link trends in short-term interest rates, and bond yields too, to economic developments. Too often they are subject to what an anthropologist might call fetishism. That is, yields are seen to be endowed with inherent powers rather than being the product of external forces.
Central bankers and market participants have warned of the dangers of seeing rates in too narrow a context. Ben Bernanke, in a speech in 2013, when he was still chairman of the US Federal Reserve, argued that: “A more complete explanation of the current low level of rates must take account of the broader economic environment in which central banks are currently operating and of the constraints that that environment places on their policy choices.” Chris Iggo, chief investment officer for global fixed income at AXA Investment Managers (Axa IM), makes a similar point when he argues that: “Monetary policy itself is a reaction to other broader factors.”
Nevertheless the error is understandable. For those following the fixed income markets it is easy to become so fixated on yields that the bigger picture is missed. There is such an intense focus on developments in the markets that the relationship to the outside world recedes into the background or even disappears.
This overview of the fixed income markets will self-consciously distance itself from these limitations. Instead of focusing on days and months its perspective will be that of years and decades. Rather than discussing bonds in themselves it will relate them to the wider world.
The advantage of such an approach is that it helps bring out the peculiarity of the current situation. Relatively few observers are likely to realise that real bond yields in the advanced economies have trended downwards for over three decades (figure 1). It is only once this is appreciated that it is possible to have a sensible discussion of their likely upward trajectory.
Once these long-term trends are recognised it naturally raises the question of why yields trended downwards for so long. It is highly unlikely to have happened by chance. Nor can it solely be the result of central bank policy. Deeper forces must have driven these secular shifts.
The long way down
With the current inflation rate running at just above zero it is sobering to remember how high it once was (see figure 2). The annual inflation rate in the US peaked at 13.5% in 1980 according to the Bureau of Labor Statistics. That is still a world away from the hyperinflation in Weimar Germany in the early 1920s but it is substantial nevertheless. Even in the early 1980s there was a strong incentive for consumers to spend, rather than save, since the price of goods was appreciating rapidly. There was also a temptation for unions to demand high wage increases simply to keep pace with rising prices.
Of course, inflation cannot be the whole story in relation to bond yields. They have fallen in real terms (adjusted for inflation) as well as in nominal terms. But for most economists and bond fund managers it is an important part of the picture.
In fact, there is a broad consensus among experts on why bond yields trended downwards for so long. Different authorities emphasise different points but they tend to have much in common. They also generally agree that the important forces were different at various times. For example, in recent years, measures such as quantitative easing (QE), asset purchasing programmes by central banks, pushed up bond prices by increasing demand. It follows, since they move in the opposite directions to prices, that yields have fallen.
But simply focusing on the years since the global financial crisis is also a mistake. QE may be a large part of the explanation for rising yields since 2008 but it cannot account for the long downward trend before that.
The first part of the story of falling yields, and the decisive factor in the early period, is usually attributed to hawkish anti-inflationary policies. In particular, Paul Volcker, the chairman of the Fed from 1979 to 1987, is often lauded for this tough line on inflation. Under his regime the effective federal funds rate hit over 19% in the early 1980s (figure 3).
Mark Cernicky, managing director in the global fixed income team at Principal Global Investors (PGI), probably speaks for many when he argues that: “The first big movement was Volker stamping on inflation. Constricting the money supply and pushing yields down. That really began this whole secular trend.”
Demographic shifts are useless at explaining short-term shifts in bond yields but they are widely seen as important long-term drivers of change. Older societies tend to save more than younger ones. The preference for bonds over equities also generally increases with age as older investors generally desire the safety of bonds and the income they provide.
So, although demographic factors are not the only ones at work they could provide part of the explanation for rising yields. In the US, for instance, the median age has increased from about 30 years in 1950 to about 37 today. If anything the trend is even more pronounced in countries such as Germany and Japan. With average ages of about 46 years both are among the oldest populations in the world.
However, Axa IM’s Iggo argues that this trend could reverse. The baby boomer generation is starting to retire from the labour market and spend its savings. If he is right the effect of demographics could become the opposite of that in the past and the ageing population could put an upward pressure on yields rather than a downward one.
The term ‘globalisation’ is used to mean many different things. For economists, for example, it often refers to the internationalisation of trade and financial flows. For others it can convey a sense that the world is spiralling out of control. In relation to the debate about inflation and bond yields it tends to refer to the removal of key barriers between economies. As a result labour is, in effect, competing much more freely.
It is hard to believe now but until the 1980s or so the world economy was highly segmented. The Soviet bloc, as it then was, engaged in relatively little trade with the West. China had started on its path to rapid development but was still in its early stages. Even countries such as India, which were not aligned with the Soviet Union or the West, engaged in relatively little trade.
Compare that with the situation today. For example, in relation to China not only has trade increased as a proportion of GDP but the economy has also grown hugely in absolute terms. In effect, hundreds of millions of Chinese workers have joined the world economy. Their joint efforts have put a downward pressure on consumer prices and so helped keep inflation in check.
The savings glut
Jim Cielinski, head of fixed income at Columbia Threadneedle, describes this sharp fall in global labour costs as “a powerful deflationary force”. He also says it has played an important role in creating what is often referred to as global savings glut. The idea is that many emerging economies, as they have become richer, have increased their level of savings. Much of these excess savings have in turn found their way into Western bond markets.
After the Asian financial crisis of 1997-98 the trend became stronger. Many countries decided they needed to keep a reasonable stock of assets in reserve to help protect themselves against violent currency fluctuations.
However it is not just emerging economies that have built up their savings. Advanced economies with current account surpluses, most notably Germany and (in earlier years) Japan, have also reinvested their savings. The counterpart to this trend is the large current account deficit countries, such as the US and the UK, which have seen substantial inflows. In effect, flows from other countries have helped support the US and British bond markets.
Although the explanations above are the most commonly identified, the list is far from exhaustive. Several others are sometimes discussed including the breaking of trade union power in the 1980s (so weakening their capacity to push up wages); the rise of income inequality (since the rich tend to consume less and save more relative to their incomes); and the internet’s role in allowing consumers to discover the cheapest prices for goods and services.
For most experts the combination of the trends outlined so far was mutually reinforcing. Together they created the long-term downward trend in bond yields. Given that government bond yields are in many cases close to zero, and in some instances negative, it is reasonable to assume they will start going up sooner or later. The tricky question is how far and how fast the upward path is likely to be.
An uncertain path upwards
Although the downward movement of bonds yields is clear the likely upward path is more difficult to discern. This is largely because the future inevitably contains a great deal of uncertainty. Nevertheless, outlining past trends helps provide a starting point for thinking about the foreseeable future.
In the short term it is certainly possible that the unwinding of QE could cause market volatility. The prospective upward moves in interest rates have received substantial attention but the reversal of unconventional monetary policy is less remarked on.
PGI’s Mark Cernicky anticipates that when the Fed starts selling mortgage-backed securities (which were part of the QE scheme) it is likely to put technical pressure on the market. This could create a ripple effect that could spill over into investment grade bonds and high yield.
There is also the possibility that QE’s effect on shoring up sagging economies will start to diminish. For Columbia Threadneedle’s Cielinski, each time QE is used “it becomes less and less credible”. If he is right it could be a particular problem for the European Central Bank as it is still in the process of expanding its asset purchases.
Capital Economics, an economics consultancy, disagrees. Joseph Jessop, its chief global economist, argued in a recent circular that central banks are not as impotent as often suggested (‘Are central banks really running out of ammunition?’, 1 September 2015). He said that central banks’ record on meeting their inflation targets is better than generally assumed and they still have many ways to influence inflationary expectations.
Over the longer term it is worth first considering the possibility that the particularly high interest rates of the late 1970s and early were an aberration. That is certainly the view of Colin Graham, CIO of BNP Paribas Investment Partners’ multi asset solutions business. “High inflation really came through with the end of fixed exchange rates [in the early 1970s] as economies started to adjust”, he says. He also argues that the oil price spikes in that decade helped push up inflation.
This alone would suggest that the upward movement in rates is unlikely to be a reflection of their downward path. Even if there is mean reversion it does not necessarily follow that the average level of yields can be identified easily. Certainly, the consensus is that the rise in yields is likely to be long and drawn-out.
This is despite the fact that some of the trends that pushed bond yields down are unlikely to be repeated. For instance, it is hard to imagine an equivalent impact to China joining the world economy. That is not to say that China will reverse its position and distance itself from global trade and investment. Only that it is hard to imagine a new impetus along the lines of China’s earlier movement.
It is more likely that China will diversify further away from US assets and even decrease its holdings of other overseas bonds. There were tentative signs of this possibility in August when China drew on its foreign exchange reserves to help shore up the renminbi. In any case, if the Chinese currency is accepted in the International Monetary Fund (IMF) scheme for Special Drawing Rights it will have less need for dollar reserves.
Less than zero
It is also hard to see how inflation can go any lower than it is as present, since in many places it is already close to zero. There is, certainly mathematically, a chance that the world will enter an era of falling prices. Indeed some commentators see this as a significant risk. But that is a different type of challenge than that of rampant inflation.
In fact, it is the possibility of slow global growth that is a key argument for expecting yields to remain low for a prolonged period. Growth in much of the developed world is weak and China’s economic expansion is slowing. Many influential economists and the IMF have endorsed the idea that the advanced economies are suffering from “secular stagnation”.
Not all experts agree. For example, Graham says that “secular stagnation is not part of our thesis”. In his view the global economy looks set to recover. It should not be long before the final effects of the financial crisis are overcome.
In contrast to the spectre of deflation the possibility of resurgent inflation is widely dismissed. Back in 2008-09, with the advent of QE, many commentators warned of inflationary dangers. But such predictions have gone out of fashion as this spectre has failed to materialise.
Not everyone accepts the consensus on this question. Iggo argues: “The longer we have interest rates at zero and QE being pumped into the world economy there is an inflation risk at some point”. He points out that, although consumer prices have only increased slowly, the prices of many financial assets have surged. For a young person hoping to buy a house, for instance, rising prices are a form of inflation even if they are not included in a consumer price index.
Fixed income investors who have held bonds in long-term portfolios for the past 30 years or so are likely to have made handsome returns. Although few anticipate a bear market of a similar length the path ahead is likely to be more difficult to navigate than that enjoyed in recent decades.
Memories of the 1994 bond market turmoil
There is a reasonable case to make that the bond market turmoil of 1994 – now largely forgotten – has many parallels with the current situation. The US was coming out of the recession of the early 1990s, the Fed had left interest rates unchanged through the whole of 1993 and global real interest rates had trended downwards for many years (see figure 1).
Roland van den Brink, a Dutch pension fund veteran and former CIO, recalls the situation back then. “Since about 1982 we had a bond market where yields were going downwards. So imagine you are in a situation where yields are going down for 12 years,” he says. “Then some people start to think there should be an end to this cycle.”
Volatility started to increase soon after the Fed raised rates by a quarter point on 4 February 1994 – although it had already started to become apparent in Japan in January. Bond yields rose substantially in the subsequent months and hundreds of billions of dollars were knocked off the value of US bonds.
When rates started to rise there was little sense that the markets could be over-reacting. “No one was rushing to take the opposite position as everyone had an implicit feeling that this was the bottom,” says van den Brink. “Markets moved very rapidly.” In his view, asset managers at the time were acting like lemmings – almost as if they had a death wish to lose money.
Axa Investment Managers’ Chris Iggo, who was an economist for Chase Manhattan in New York at the time, agrees the market reaction at the time was one of panic. “Yes, there was panic. There was a lot of money lost. There was volatility.”
The hope among asset managers and central bankers today is that they have learned from the experience of the past.
It was only after the 1994 turmoil that central banks became more transparent. Back then central bankers were deliberately opaque about their decisions rather than routinely publishing statements and minutes as they do now. Columbia Threadneedle’s Jim Cielinski says: “Since then central banks have been quite careful to telegraph their intentions”.
If anything it could be that central banks have gone too far in the opposite direction. Sometimes they seem overly anxious about making any decisive moves. Despite the 1994 turmoil it is worth remembering that in some respects there was a happy aftermath. The following year was one of particularly strong bond market returns.
Fixed Income Challenges: These peculiar times
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An uncertain path