Staying informed of the current economic environment is important for individual investors and employers selecting investment options for retirement plan participants. This post will explain some of the possible reasons for one such topic—the current strength of the bond markets: higher bond prices and lower yields for most government bonds.
Professional Money Managers and individual investors are puzzled by the recent rally in bond markets, especially considering the stock market is rallying as well. Bonds have continued to catch a strong bid (the opposite of what is expected) as stocks are making new highs and the economic data has firmed up here in the US. Conventional wisdom states a rallying bond market (and falling yields) means an economic slowdown; however, the economy continues to indicate good momentum in the 2nd
quarter, and although we’re experiencing a rallying bond market, we are not experiencing an economic slowdown as we enter the tail-end of the 2nd
Possible reasons for the current strength in the bond markets:
- Lower overall economic growth and low inflation: Table 1 below shows data points from some of the key economies around the world. Notice the moderate GDP growth (Y/Y), relatively low inflation and the low 10-year government bond yields in some of the key developed economies around the world (Esp. USA, Germany, Japan and the EU). Despite the massive QE (bond buying) programs in Japan and the US, the year-over-year growth in those economies has been mediocre at best, inflation is still moderate and the bond market is reflecting this reality.
- Europe still remains a wild card and faces a slower growth environment: In early June 2014 and in response to the consistently low inflation and overall low growth environment, the European Central Bank (ECB) lowered the benchmark lending rate by 10 basis points to 0.15 percent, and lowered its deposit rate to minus 0.1 percent, becoming the first major central bank to make one of its main rates negative. And, in a bid to get credit flowing to parts of the economy that need it, the ECB also opened a 400-billion-euro ($542 billion) liquidity channel tied to bank lending. The recent geo-political tensions in Ukraine add to the fears of economic uncertainty and generate some safety demand for bonds.
- China continues to experience slowing growth: China’s government is trying to rein in excessive growth in shadow banking systems and strengthen control of local government borrowing, resulting in a slowing growth environment over the last few quarters.
- Improving US Budget Deficits: The US budget deficits have come down from over 12% deficit (as % of GDP) at the height of the recession in 2009-2010, to just above 4% deficit. Improving the fiscal situation while the Federal Reserve is still buying US government debt (treasuries and mortgage bonds) has obviously helped the bond market.
- Strong Appetite for long duration bonds from Pension Plans and Insurance Companies: With inflation relatively tame, and demographics favoring more bond allocations in some of their portfolios, demand for long-duration bonds from pension plans and insurance companies remains high as they try to match liabilities with assets.
- Short-covering by professional traders and hedge fund managers provide fuel to the rally: As of May 27, hedge funds and other large speculators cut net short positions in 10-year note futures by the most since February, according to the U.S. Commodity Futures Trading Commission. Primary dealers, who had net short positions in March for the first time since 2011, have since reversed those wagers, as shown by Bloomberg. Short covering usually leads to higher prices for the underlying asset and supports the higher prices in bond.
PIMCO’s Bill Gross calls the current environment of high global leverage (see chart 1 below), low growth, and low inflation, “the new neutral”
. He anticipates that over the next few years, monetary policy makers will be forced to keep rates low in order to sustain growth and support higher-risk asset prices.
Mr. Gross anticipates a likely investment/policy outcome of global economies operating in a multi-speed world with countries converging to historically modest trend rates of potential growth, low inflation and a 0% neutral real policy rate for many developed and some developing countries. Correspondingly, his outlook on the 10-year US Treasury bond yields is 2.5% to 4.00%.
Former Federal Reserve chairman, Ben Bernanke, has also indicated that rates will take a much longer time to normalize than most people expect and that Fed fund rates may not rise above the 4% level during his lifetime.
While the current rally in bonds may be maturing and rates may perk up a bit higher if the economic data continues to strengthen, it appears that rates and bond markets will be relatively well-behaved over the next 2-3 years, and the US 10-year treasury rate will likely stay in the “New Neutral” range.
For US investors concerned about a sharply rising interest rate environment and a hyper-inflationary scenario, notice Japan’s debt ratios and the Japanese 10-year government bond yields in the table above. The 10-year Japanese government bond yield is currently at 0.59%, with inflation above 3% and debt-to-GDP ratio over 200%. Japan is finally seeing some inflation, and yet, government bond yields have not risen with rising inflation and rising economic growth.
In the intermediate-term future, we anticipate any additional adjustment due to the Fed’s policies would likely show up on the currency depreciation side of the equation as opposed to raising interest rates.
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