Investors that buy developed markets government bonds have been faced with unpalatably skimpy or even negative yields on offer for some time. The question is no longer why, but for how long? Fed funds futures and benchmark ten-year US Treasuries suggest the answer is several more years, a similar timeline to other markets. But as we know, markets have a tendency to surprise.
Fed funds futures are not pricing in a 25 basis point (bp) rise until early 2017, while the US Treasury implied forward curve shows ten-year yields rising to only 2.15% over the next five years. Skeptics argue that this grossly understates the risk of a more abrupt reversal in yield trend, as a tightening US labor market and bottoming commodity prices could easily cause a rebound in headline inflation much sooner than five years. This would at last liberate the Federal Reserve to normalize rates at a more, well, normal pace. This is not what the market expects, with US bonds implying an average inflation rate of around 1.6% over the coming decade, not far off the current rate of around 1%. Similarly, the five-year, five-year forward CPI swap rate shows an expectation of 1.93% inflation in five years’ time.
Of course, there are good fundamental and technical reasons why benchmark government bond yields should stay very low for a long time. Most notably, the level of global indebtedness has increased since the financial crisis and continues to exert a powerful deflationary force on the global economy. Japan’s latest attempts to boost growth through yet another fiscal spending package and its recently postponed sales tax increase are testimony to the difficulty of overcoming this debt hurdle. With the Bank of England cutting rates by 25 bps and resuming quantitative easing, and the European Central Bank continuing to buy bonds well into next year, bond yields outside the United States will remain pinned down, thereby rendering US bond yields relatively attractive to international investors.
While many are worried the US presidential election could be a joker in the pack, both candidates’ announced plans seem unlikely to upset bond markets on their own. Details of their proposals remain sketchy, but thus far neither has suggested infrastructure spending that would represent more than about 0.5% of GDP per annum. That said, given the unprecedented nature of this election, this area bears watching.
US economic growth remains subpar seven years into the recovery, and the Fed says it has been constrained from effecting a second rate rise by the fragility of the global economy. Of course it is possible the steady rate of job creation in the United States will continue to buoy the consumer, thereby mopping up spare capacity. This would translate into higher wage growth and more productive investment by businesses and ignite a new, more robust phase in the recovery that does not depend on re-leveraging. However, this would not only be a big surprise, but would clearly exert pressure on profit margins, compounded by a likely resumption of the dollar’s upward march in anticipation of Fed rate hikes. In this scenario, it would make sense for the Fed to lag behind any rise in the rate of nominal GDP growth in order to bring down the real value of debt to GDP and dampen the dollar’s strength. Whether the markets would allow the Fed to go down this route is another question.
The alternative scenario is that the one-off bounce in the US economy from ultra-low rates and yields starts to flag, as recent demand for autos and housing has partly been financed through (wait for it . . .) new debt. With few bullets remaining, the Fed would presumably consider firing up the helicopters, famously suggested by former Fed chairman Ben Bernanke.
Neither scenario is reassuring for bond investors, as either bond yields will rise, or real yields will fall, if financial repression is combined with ever more aggressive policy. As for timetable, no one can say on the basis of theory, and empirical evidence remains decidedly mixed. That said, perhaps the rising level of political discontent within developed countries means that, barring signs of a more robust recovery, the pressure for even more extreme expansionary policies will become irresistible.
Stephen Saint-Leger is a Managing Director on the Cambridge Associates Global Investment Research team.