The evolution of global bond market yields: a bond trader's perspective
21 March 2018 | Markets and Economy
Commentary by Christie Gonçalves, government bond trader for Vanguard Asset Management.
Fixed income has been the focus of much attention in recent months, with many investors concerned that the bond bull market may be coming to an end. It's true that market conditions have changed ‒ central banks are cutting back on quantitative easting (QE), inflation appears to be on the rise and interest rates look set to increase further. However, the impact and extent of these changes are unclear. Examining these changes in more depth and taking a closer look at bond yields over time paints a more positive picture, and encourages investors to take a more strategic approach to the bond market.
Where have yields been historically?
Looking back at the evolution of the US 10-year bond yield over the last three decades, many investors will be surprised to see that it was close to 10% in 1987 and has trended downwards all the way to the current level of below 3%. European and UK bond yields have followed a similar trajectory over the 30-year period, as shown in the chart below, with a number of corrections on the way. Prior to the Global Financial Crisis (GFC), in the period between 2000 and 2007, yields were around 5% and were in fact considered low for the time. The current yields are therefore nothing new.
Figure 1 – Bond yields have taken a long journey down to current levels
Focusing in on the last decade, yields have continued this downwards trend. The driver of this trend can be explained in two words: central banks. The US Federal Reserve was the first major central bank to react to the GFC by launching a programme of unconventional monetary policy, known as QE, in December 2008. The impact of this was a sharp drop in global bond yields.
After years of US-driven QE, global bond yields experienced a slight correction in 2013 when the Fed hinted that it would start to "taper" its QE programme (the so-called taper tantrum). Fortunately for global bond yields, the Bank of Japan stepped in and announced an even bigger purchase programme in 2014, followed by the European Central Bank (ECB), which began its own version of QE in 2015, buying not only government bonds but also corporate issues. With global financial markets awash with cash, it is no wonder we saw bond yields take a further leg lower, with the German 10-year bund trading into negative territory.
As the Fed was so much further along in the cycle than the other global central banks, it was ready for the first interest rate hike since the GFC in December 2015. Another increase followed in December 2016, and three more in 2017. Despite the Fed having raised rates five times in a cycle, yields remained anchored. This is because of the effect of "exported QE", where global capital flows to the markets where the returns are most attractive. We will examine this effect in more detail below.
Why are investors so worried now?
1. Central banks are beginning to reduce their support of markets. Following its five hikes, the Fed started scaling back its balance sheet late in 2017. This entails allowing cash from assets that mature to expire instead of being reinvested. The Bank of England increased rates for the first time in a decade in November 2017, and in January this year, the ECB halved its QE programme, with a high likelihood that it will end completely in October.
The chart below shows the decline in central bank support, as demonstrated by the reduction in stimulus. With less central bank support for the economy, the expectation is that yields will drift higher.
Figure 2: Central bank confidence in global recovery is leading to less monetary support
Source: Vanguard calculations, based on Macrobond data as at 21 February 2018.
2. The net supply of government bonds is turning positive. In 2017, central banks bought more government bonds than were issued, resulting in negative net supply. According to current BNP Paribas estimates, markets will have to absorb USD 800 billion more debt this year globally, with many countries in the euro area moving from negative net supply last year to positive net supply after QE this year. With an increase in supply and less demand from the ECB, bond yields are expected to go up.
3. Inflation is on the rise. Breakevens, which are a measure of the market expectations of inflation, are on the rise. In the US, 10-year breakevens are now above the Fed's inflation target of 2%. Factors such as petrol price increases, wage growth and fiscal stimulus plans – tax cuts and infrastructure spend – all contribute to higher inflation expectations. In theory, higher inflation should lead to higher yields and therefore lower bond prices.
Should investors be worried?
It's true that yields have increased recently. We have seen a swift rise in the 10-year US bond yield, which is now approaching 3%. At the same time, there has also been an increase in volatility, with the CBOE Volatility Index reaching a multi-year high of 50. Consequently, many industry commentators are now talking of the start of a bear market in bonds.
The environment is changing, but it's important to bear in mind that this is a process of normalisation: central banks are withdrawing the extraordinary emergency measures they employed to offset the effects of the GFC. They are now acting from what they feel is a position of strength, the emergency measures having succeeded in meeting their aims with global growth improving.
What should investors bear in mind?
Investors should remember two things. Firstly, it's difficult to anticipate how the market will respond. Similar headlines about the US 10-year bond hitting a 3% yield proliferated at the beginning of 2017. However, last year, global fixed income enjoyed its best year in a decade, with the Bloomberg Barclays Global Aggregate Bond Index returning 7.4% (2.04% in sterling) to investors.
Secondly, there are mitigating factors that investors should pay attention to. Central banks are beginning to reduce their support of the markets, but will continue to be supportive overall, and any reduction in stimulus will be gradual. QE is also still being added in the euro area and in Japan, albeit at a slower pace. The stock of bonds on central bank balance sheets still remains high (around €12.7 trillion as of the beginning of January 2018) and this will act to weigh on yields far into the future. The rate of change is declining, but is unlikely to turn negative at least until 2019.
The effect of "exported QE"
We mentioned earlier the impact of "exported QE", when money flows to the markets which have more attractive returns This has the effect of keeping yields lower than would be justified by the central bank policy in that market. Consider an investor in Japan who is getting increasingly negative returns on their assets due to the QE effect there. However, if they are able to buy US Treasuries at above 2%, that is a much better investment. We saw this in 2016 and 2017, when Japanese investors invested €87.6 billion in US sovereign bonds. This effect can be seen in the suppressed US bond yields over 2016 and 2017 in Figure 1, despite the less accommodative monetary policy in the US.
Interest rates are rising, but we don't believe that they are headed back to where they were three decades ago, as we are in a new environment of lower real equilibrium rates and lower global returns than in previous cycles. Similarly, we don't expect inflation to rise quickly or to levels that we have seen in the past, meaning we are unlikely to see a corresponding sharp rise in yields.
Investors may read the headlines and worry, but they should bear in mind that we've been here before. Timing the market consistently is extremely difficult. A better approach may be a globally diversified portfolio which, along with equities, has an allocation to both government and corporate bonds, two sub-asset classes which don't always move together, meaning there can be a diversification benefit. Investors should also remember the vital risk-dampening role bonds play in a diversified portfolio – fixed income tends to have a drawdown that is much lower than equities, and can therefore be a safer long-term investment.
Government bond trader, Vanguard Asset Management
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