Bonds

After eight years of incredibly low bond yields in the US, the (albeit short lived) ‘Trump Bump’, has left investors guessing as to whether the secular low in fixed income has now passed, particularly with the Fed starting to exercise some of its tightening muscles. This is something that hasn’t been seen for close to a decade. Indeed, the mammoth QE stimulus globally, unprecedented ZIRP and even NIRP policies, mean yields in the bond market have been kept on the floor.

After eight years of incredibly low bond yields in the US, the (albeit short lived) ‘Trump Bump’, has left investors guessing as to whether the secular low in fixed income has now passed, particularly with the Fed starting to exercise some of its tightening muscles. This is something that hasn’t been seen for close to a decade. Indeed, the mammoth QE stimulus globally, unprecedented ZIRP and even NIRP policies, mean yields in the bond market have been kept on the floor.

But as each increasingly negative economic data report is followed by more weak data, concern is building that a more hawkish Fed could not only stifle any hopes of recovery, but more significantly, bring into question the wider health of the world’s largest economy. The fear is that servicing the growing debt pile at higher interest rates starts to become unsustainably expensive.

The elephant in the room, of course, – or the $4.5 trillion dollar question, as Julian Brigden set out in his June 2017 Real Vision presentation is what happens to yields when the Fed starts to reduce its balance sheet. The subject was also broached in the Real Vision Publications Weekly Hack – Bond Yields – You Aint Seen Nothing Yet.  where we examine the state of limbo in the bond market.

While over the short term it has been increasingly hard to call the direction in the bond market, the long term structural case for lower bond yields, as espoused by Raoul Pal, when he said ‘Everyone’s Got It Wrong on Bonds’ on Real Vision, is that we are in a deflationary environment with too much debt. This is worsened by the global demographic picture of an aging population and the ready to retire baby boomers. It is argued that these factors will force interest rates and bond yields lower over a multi year time frame.

Japan Debt to GDP vs Japanese Bond Yields

The conditions resulting from an extended period of ultra low and in some places, negative interest rates, perpetuate the deflationary theory, preventing creative destruction. That means some companies (that by rights should be out of business), are able to survive on cheap credit, resulting in a proliferation of zombie companies.

Applying this theory to the commodities market, it is hard to see where inflation and higher bond yields will come from, as otherwise struggling companies in the US shale industry continue to produce supply and keep oil prices under pressure in a deflationary environment, suggesting we could see another test lower in yields.

Bond bears on the other hand, who anticipate higher bond yields over time, argue that going by the current levels of growth and employment, interest rates should be higher than where we stand. With the US arguably at full employment, it is proposed that economic conditions do not warrant such low interest rates.

If everything eventually reverts to the mean then we could indeed see higher yields, but over the short term, the direction remains unclear. After eight years of failing to stimulate the economy through low interest rates and QE bond purchases, despite equity markets attaining successive new highs, we could be in more of a stagflation scenario.