Chris Iggo, CIO Fixed Income at AXA Investment Managers warns that bond markets may reach a turning point.
Yields have fallen for years, credit spreads have narrowed for years, and now the slope of the yield curve is flattening. This could be interpreted as the last leg of the bond bull market. It is happening with very modest monetary tightening at very low levels of interest rates.
Thus, it is different this time and the reason is that there is possibly a new normal interest rate level. But not everything can be different. A flattening yield curve could spell trouble for the economy and other asset markets. The last leg of the bond bull market might be upon us but the risk is this signals slowdown and a bear market elsewhere.
The bond bull market has had many dimensions. The big picture is a bull market of 30 years in the making as bond yields have fallen in parallel with inflation and interest rates. Since the “great financial crisis” (GFC), the bull market has been driven by a complex interaction of policy, de-leveraging and lower growth. More recently the search for yield has sustained unexpected rates of return for bond investors. In practice this has meant lower yields but also lower credit, term and inflation risk premiums. Today risk premiums appear to have been squeezed as much as possible with the possible exception of yield curve spreads. As such, the recent narrowing of the slope of the US Treasury yield curve may be telling us that the last bull market trade is rapidly playing out.
Bond bull market – trade number one – falling yields (a 30-year story)
A large number of factors have been responsible for the long bull market in bonds. Most important has been the secular decline in inflation since the early 1980s which has subsequently been associated with lower and lower levels of official interest rates. A secondary influence has been the globalisation of trade and capital flows that has allowed large trade surpluses, the result of imbalances in global savings and investment, to be allocated across capital markets, helping reduce real interest rates. More recently, regulation, demographics and unorthodox policies by central banks have contributed to historical lows in yields. This year saw new lows in yields across many government bond and other sectors despite the world having passed “peak quantitative easing (QE)”. The fact that the global economy is the most synchronised it has been since before the GFC and that global spare capacity is being used up and central banks are talking about and actually practicing – in some cases – normalisation, yields remain close to their lows. However, they do seem to have bottomed. The lows reached in the last couple of years will be difficult to breach again in this cycle. Central banks are committed to raising inflation, growth is strong, fiscal policy is less restrictive and about to become more positive in the United States. Getting excess returns from betting on further significant declines in the level of bond yields will be difficult. This leg of the bull market is over.
Bond bull market – trade number two – squeeze credit risk premiums (a decade long story)
As central banks cut interest rates to close to zero after the GFC, the search for yield began to dominate fixed income markets. The high level of credit spreads following the recession gave investors a great opportunity to benefit from the economic recovery. Central bank purchases also boosted credit markets – directly through central banks buying corporate bonds and indirectly through forcing investors into higher yielding credit. So the last few years have seen a trend decline in credit spreads. They were lower, in many cases, before the GFC when the structured bid for credit was a major technical influence on the markets, but since the crisis this has not been present such that the post-crisis lows are not as low as the pre-crisis ones, but they are still low. This year spreads have continued to narrow, buoyed by good fundamentals and the persistent search for yield. There remains a belief that credit risk is well contained. However, at these low levels of credit risk premium it is hard to be very bullish on the prospect for significant excess returns. While defaults in investment grade are rare, investors can still face impairments to capital from downgrades and marked-to-market pricing and it seems likely that today’s “perfect” credit environment will suffer some deterioration in the future. In high yield markets, defaults will rise at some point. Thus we could be close to the low in credit spreads. Indeed, over the last month, high yield credit markets have been instructive. Spreads narrowed aggressively in October only to widen just as aggressively in November on the merest hint that the credit cycle might be turning. At today’s levels, credit market spreads do offer a potential positive excess return over risk-free assets, but only if credit conditions remain benign. There is not much of a buffer in the level of spreads to compensate investors for any deterioration in credit quality. As such the credit bull leg of the cycle is over too.
Bond bull market – trade number three – back to sovereigns and late cycle curve flattening?
Considering where they have come from in recent years, the prospect for further declines in the overall level of yields and in the level of credit spreads is limited. There is now a reduced opportunity set for being “directionally” long fixed income or for being aggressively long credit risk. What is different about this cycle is that the lows in rates and in spreads have been contemporaneous. Normally, at this stage of the cycle, short-term interest rates would have increased in response to strong growth and there would be a more obvious negative correlation between interest rate levels and credit spreads. There has been some monetary tightening in the US and this has contributed to a marked flattening of the US yield curve. However, elsewhere, interest rates remain close to zero and curves relatively steep. The argument that the curve flattening trade is the last bull market opportunity rests on two dimensions – a fundamental one and a technical one. Let’s take the fundamental one. A lot of work has been done in the US on estimating what the real natural rate of interest is today relative to the past. Many economists say that this “r-star” interest rate is much lower because of lower trend growth and productivity. If this is correct, then the amount of monetary tightening the Federal Reserve (Fed) needs to do to achieve a “restrictive” monetary policy is much less than in the past (i.e. the natural rate of interest is lower compared to the past so short-rates don’t need to go up that much). As long-term interest rates reflect the average of short-term interest rates through the economic cycle, they will also be lower than in the past. As such, 10-year yields are likely to be range-bound around current levels (2.25-2.75%) meaning there is a profitable trade in betting that the slope between 2-year yields and 10-year yields declines further. Investors should feel comfortable in taking on longer term duration risk because the “new normal” argument means that the term risk premium has diminished. Put it this way, if there is no inflation risk you are happy to hold low yielding assets, if there is no credit risk you are happy to hold assets with skimpy credit risk premiums and if there is no term premium risk then you are happy to hold longer duration assets during the monetary tightening phase as there is a limit to how far short term rates can rise. That is embedded in the longer term structure of bond yields.
Technically bullish – With me so far?
The other argument rests on technical factors. Quantitative easing means that central banks own a lot of outstanding government debt. In the US, once the Fed, other government agencies and foreigners have been taken into account, the amount of Treasury debt available to private sector US investors is only about $6trn (out of $20trn). Given the demand for bonds driven by demographics and regulation, no wonder yields are low. These arguments can be applied to other economies even if they are at different stages of the cycle relative to the US. The natural rate of interest in the euro area is surely lower than in the past given low trend growth and structural rigidities. Same for Japan where demography is the key factor. Thus even if the European Central Bank (ECB) and Bank of Japan (BoJ) ever get around to raising interest rates, they won’t be able to do very much. Of course, the technical dimension is still very relevant to those bond markets where QE is still in progress. As such, why not buy the longer end of yield curves where the level of yields is still a lot higher than short term interest rates?
Is it the end? – The logic of the “new normal” argument is that the Fed is well advanced in terms of monetary tightening. If we take the slope of the curve today it is at 60 basis points (bps). Three more rate hikes would move policy into restrictive territory. If the logic holds, the economy will then slow and risk assets should underperform. In other words, credit spreads will widen and equities will de-rate. Of course, curves can flatten in a bearish way – i.e. the whole level of yields can move higher but shorter dated bonds underperform the long-end. But this is not happening today. It is a bullish curve flattening based on the view that long-term yields are not going higher. We also see it at the very long end of the German and UK yield curves as well where the 30-year sector has been outperforming. If you believe the scope for higher short term interest rates is limited because of secular stagnation, why not buy higher yielding longer maturity bonds and play the carry and roll down trade?
But the economy! – This argument will sit uncomfortably with some investors. After all, fundamentals look solid and recession signals are absent. Monetary policy is very accommodative in the rest of the world and there is still a risk that inflation could rise in 2018. Yet the curve flattening in the US has a strong momentum. It could be a false signal and it could reverse, particularly if the technical picture changes with Fed balance sheet normalisation. If it is not a false signal and the bond flattening plays out, what next for bond investors? The next bull market will come with only limited scope for yields to fall but there might be some interesting credit opportunities. Before then, enjoy the finale.
Something new needed – I was in Manchester for the Newcastle game last week and enjoyed the four goals from United. But the inconsistency struck again in mid-week with a defeat to Basel despite having numerous chances to put the game to bed. I can’t put my finger on what is really the problem. A lack of urgency going forward? Weakness in some of the defensive positions? No real creativity on the wings? A lack of imagination when Pogba is out of the team? Jose needs to sort it or United will struggle to keep up with City and will find the knock-out stages of the Champions League difficult. The potential is there but it is not being fulfilled at the moment. I expect the accountants are totting up the available funds for January.