Adam Chester, Head of Economics, Lloyds Bank Commercial Banking
Are global bond markets in the early stages of a substantial sell-off? That’s the question occupying not only bond investors, but investors in all asset classes that rely on yields to discount their future earnings streams. Since the onset of the financial crisis, there have been periodic bouts of bond market turbulence, but this time looks different, with the economic backdrop appearing more conducive to a sustained sell-off. The global economy is growing at its fastest rate for seven years, inflation pressures appear to be building, and the interest rate cycle is finally turning higher.
Since last September, the yield on the 10-year US benchmark Treasury has risen by almost 100bpand is now close to its highest for over four years. In the UK and Germany, the rise in bond yields has not been as marked, but, even so, 10-year gilt yields are over 50bp higher than they were last September, while 10-year German bund yields are up around 40bp. So where do yields go from here?
To gauge the outlook, it’s useful to view the bond markets through a different lens.
Deconstructing bond yields
Bond investors require compensation for investing in a nominal asset with a fixed income. This comes in three forms: a risk-free real yield, an inflation expectation and a risk premium. Theoretically, the risk-free real yield should be the same across all asset classes (in all countries), and represents the inflation and risk-adjusted return required for consumption today. The inflation component compensates an investor for what would otherwise be an erosion of the real value of their investment. And the risk premium covers everything else – including compensation for liquidity, fiscal, exchange rate and inflation risk (the potential volatility of future inflation outcomes). While it is not possible to observe the size of the risk premium directly, by adopting this framework a clearer sense emerges of what has driven yields higher, and where they may go from here.
It is clear that the rise in US 10-year Treasury yields in recent months has been caused by a rise in inflation expectations and real yields in broadly equal measure. But looking ahead there appears to be limited scope for inflation expectations to rise much further. Longer-term US inflation expectations are already close to their historic average of around 2%, which looks about right given the Federal Reserve’s 2% inflation target. By contrast, 10-year real yields remain well below their pre-crisis average – a fact that also applies to other government bond markets. This suggests the most likely source of any sustained rise in nominal bond yields is now likely to be real yields, not longer-term inflation expectations.
The real threat
The recent rise in real yields in the US, and to a varying extent elsewhere, has largely been attributed to the strength of the world economy and the recent shift in central bank interest rate expectations. But what matters for real yields is not the prevailing rate of world growth, but how it evolves over the coming years. This, in turn, depends on the key drivers of trend economic growth – most notably, potential productivity.
Secondly, while rising policy rates raise short-term real interest rates, the implications for longer-term real yields are ambiguous. In extreme circumstances, an aggressive rise in short-term real interest rates could lead to a drop in longer-term real yields, if the squeeze leads to a sharp rise in saving and weaker investment in productivity. Indeed, the correlation coefficient between three-month and 10-year real yields in the US over the past twenty years has been close to zero.
More generally, real yields can be thought of as the inflation-adjusted price that brings the desired level of global savings and investment into balance. Real yields have been on a secular downtrend, reflecting the fact that desired global saving has exceeded desired global investment over this period.
There have been various reasons for this.
The strong growth of high savings economies (like China) and the post-war baby-boom generation reaching its peak savings age have played a part; as has the build-up of precautionary savings following the financial crisis; and the associated weakness of investment spending and central bond purchases (as part of central banks’ Quantitative Easing (QE) programmes).
Bond yields to rise further
If confidence in the global upswing continues, the desire to spend and invest should put real interest rates under continued pressure, though structural impediments to productivity growth mean any rise from this quarter is likely to be limited. There are other developments that may also be expected to increase real yields. These include rising budget deficits, particularly in the US following recent tax cuts, and the unwinding of central bank balance sheets. If, or rather when, central banks start to unload their QE bond purchases, the imbalance between demand and supply in the government bond markets is likely to see real yields rise.
The US ‘taper tantrum’ in early 2013 gives an indication of the sensitivity of the US bond market to a potential reversal in central bank bond holdings. This is perhaps not surprising given the US Federal Reserve currently holds around 20% of outstanding US marketable government debt, while the Bank of England’s share of gilts and T-bills is slightly larger, at 25%. The ageing population poses another potential pressure point for real yields. Arguably, this is already occurring as the baby-boom generation enters income drawdown, and rising life expectancy puts savings under greater pressure.
A synchronised upswing
There’s an old adage: ‘when the US sneezes, the rest of the world catches a cold’. To a large extent, this still holds true. The primary cause of the recent rise in global bond yields has been the sell-off in the US. If the world economy remains on a recovery path, the shift in savings and investment dynamics is likely to see US long-term real yields rise back to around 1.5%. As a broad rule of thumb, over the long term, US risk-free real yields should converge towards a long-term return on US capital. This, in turn, may be approximated by US trend GDP growth, which the OECD currently estimates to be around 1.6%.
A return to around 1.5% real yields and 2% long-term inflation expectations would leave the longer-term ‘fair value’ for 10-year US Treasury yields at around 3.5% – 70bp above their current level. The US budget deficit, the eventual unwinding of QE and demographic shifts will also play a role. The speed of the adjustment remains uncertain, but as US yields come under further pressure, those in Europe can be expected to follow.