Global bond yields on a staggered march higher – Investec’s Stopford
John Stopford, co-head of Investec Asset Management’s Global Multi Asset Team comments on global bond yields which have risen sharply since a timetable for phasing out QE was outlined by Fed chairman Ben Bernanke earlier this year.
Reflecting on recent developments, in our view the impact of the US government shutdown and short-term extension of the debt ceiling have complicated policy making for the Federal Reserve by disrupting data and data releases and creating a greater level of uncertainty about the near-term path of the economy. As such, the FOMC may consider it prudent to delay tapering further until the economic picture is clearer. This in turn would weigh on expectations of the likely path of future interest rate changes and help Treasuries to rally towards the lower end of their likely range.
The prospect of tapering had allowed bond markets to move towards more conventional pricing after a prolonged period of artificially depressed yields. Real yields, however, remain low in a historical context, and we think it is interesting to ask how far bond markets are along the road to normalisation, and how pricing might develop from here. Our views are as follows:
• In the near-term much of the likely move in yields looks to have already taken place. Focusing on the US Treasury market, which has been leading this process, we can work out from the current level of bond yields, the future path of official interest rates anticipated by bond investors. Just prior to the latest FOMC meeting, Treasuries were anticipating a faster speed of interest rate increases than implied by the Fed’s own forecasts. The decision not to begin tapering in October forced the market to reassess the outlook and allowed yields to decline. Treasury yields now again appear to be overshooting a little to the downside versus the current profile of the median path of interest rates anticipated by FOMC members.
• From here, the path of least resistance is probably for US bond yields to rise slowly by around 0.5% per annum. This would see Treasuries delivering cash-like returns, with their yield advantage over interbank rates being largely offset by capital losses. In other words, investors should probably expect a number of years of low nominal and negative real returns from government bonds. Around this path, however, there are likely to be opportunities to take advantage of swings in investor sentiment, which take yields above or below fair value. Such swings seem likely for two reasons: first, they are the norm for bond markets as investors’ expectations of future interest rates adjust to changing economic conditions. Second, the FOMC has said that the path of official interest rates will be data-dependant, suggesting that expectations will be even more sensitive than usual to a run of weaker or stronger data.
• In the near-term, we expect 10-year Treasury yields to mostly stay in a 2.5-3% range, reflecting modest adjustment to market views about the speed of US interest rate tightening. Improved data could push yields towards 3.5%, a level of yield curve steepness seen in previous periods of low official interest rates. Similarly, very soft economic data could temporarily push yields back towards 2%, on expectations of prolonged QE. The direction of yields over time, however, should be a gradually rising trend as the US economy moves closer to full employment. This fair value trend assumes that the FOMC are heading towards an eventual neutral level for the federal funds rate of about 4%. This is the current central forecast of committee members, although the more dovish participants doubt the rate will get much above 3% even in the long-term.
• A rate of 4% has some intuitive appeal, given it is close to the committee’s long-run expectation of the trend rate of nominal GDP growth. This needs to be balanced, however, against the likely behaviour of real interest rates in a time of high debt levels. Highly leveraged economies tend to have lower potential growth rates and are more sensitive to interest rate changes. In addition, policymakers may see low or negative real interest rates as a low cost way of facilitating deleveraging. The significant reduction in debt to GDP after the Second World War was certainly helped by a 35-year period when real bank rates averaged close to zero. In light of this, market participants may question whether a 4% level for the funds rate is achievable in the next rate cycle, without a clearer pick-up in inflation expectations.
• Other countries’ bond market yields have also risen to reflect the re-pricing of US interest rate expectations, with differences largely reflecting the anticipated profiles of their own policy rates. This relative pricing is typical of how bond markets behave in a competitive global market for capital. Some bond yields have perhaps risen a little too far too fast – New Zealand is a good example, with rapid interest rate increases now priced in. The UK is another, with the current run of strong economic data pushing interest rate expectations well ahead of where the Bank of England would like to see them, especially given the effective policy tightening from a stronger pound. Certain other markets, notably Japanese government bonds, have moved by less than historical relationships would have suggested. The Bank of Japan has succeeded in keeping yields suppressed for now, but if its reflationary policy works, or even if it fails, Japanese government bond yields look set to move significantly higher over the next few years.