With the buds of spring have come tentative signs of economic optimism in the U.S., the latest of which were decent(-ish) non-farm payroll numbers last Friday. Inevitably, along with these signs of optimism, we yet again begin to hear the bond vigilantes raises their voices and argue the multi-decade bull market in yields is coming to a close.
In February of this year when 10-year Treasuries rose above 2%, I set out the historical context for this bull market using some quantitative analysis. My analysis showed and argued that even in a 30-year bull market of lower and lower yields, retracement of yields has been a standard feature. In fact, throughout the over 30 years since the Treasury bull market began, in a surprisingly large 45% of months, yields have actually gone up.
The increase in yields seen in January was in line with normal corrections seen throughout the multi-decade bull market. The conclusion of the article was that the price action in January was perfectly in line with a typical month (in quantitative terms) in this long downward march in yields, and not a reason to panic and to dump Treasuries.
This article turns to the fundamental factors that have been driving yields lower, and backs up the analysis of my previous article by arguing that a number of strong and persistent fundamental factors had been driving the downward trend in yields. Whilst these factors are still present, there is little to suggest a change in the direction of the market. Yields are set to remain low for the medium-term outlook, and investors would need to re-adjust their expectations for lower returns accordingly.
Reason No. 1 - Lower yields are not just a post-2008 phenomenon
There is often a misconception among some investors that the phenomenon of lower and lower yields is a post-2008 "new" trend that is a result of the events that followed the sub-prime crisis. In fact, as the following graph shows, the move towards low yields is a multi-decade phenomenon within a trend that has been persistent for over 20 years.
U.S. Government bond yields - A multi-year perspective of U.S. Government bond yields
The same is true if we look at corporate yields -- we are witnessing a multi-decade trend that began at the beginning of the 1980s -- not one that started with the current financial crisis.
Reason No. 2 - Synchronized global slowdown
The fact is that we are in the midst of an unparalleled synchronized global slowdown that shows no sign of picking up speed in the near future.
The following graph puts this slowdown into context -- it shows the growth rates in the G7 countries (not including Italy) over the last 30 years.
This is a multi-decade trend converging towards stabilization of growth at historically lower levels.
There are two things to notice among the mass of color:
- The convergence of the lines, or growth rates across the G7 post-2007, compared to the more dispersed rates we saw in previous decades. This is a feature that is unique to the current slowdown.
- The multi-decade trend towards lower growth rates. I have inserted a purple trend line showing the average (un-weighted) growth rate, per decade, across the countries in the sample. This slowdown is not a post-2008 phenomenon -- it's an industrialized-world multi-decade trend towards lower growth rates.
This is what Pimco has coined the "new normal" -- worldwide major economies characterized by slower pace of expansion -- along with higher unemployment and a greater government role.
Reason No. 3 - U.S. economic growth at unprecedented low levels
On a similar theme to the worldwide synchronized slowdown is the fact that the U.S. is undergoing a period of sluggish growth that is not even closely comparable to anything that has been seen in the last 100 years.
The following graph smooths out the quarterly growth figures, using a rolling 8-year average, which is useful for identifying longer-term trends.
What is evident is the magnitude of the slowdown compared to historical slowdowns -- current growth is well outside the traditional range of 3-4%, which was seen in post-war America. It dropped out of that range almost a decade ago and shows no sign of coming close to returning to historical norms.
Reason No. 4 - Japan's lesson about cycles
The assumption that we are in a normal economic cycle and that yields will "regress to the mean" within a number of years is predicated on historical experience, but ignores the fact that yields can remain low for years to come, just as we have seen in Japan.
The graph of Japanese 10-year yields is quite astonishing. After plunging from over 4% to under 2% in just over two years, it has now stayed below 2% for over 15 years -- by that count, the U.S. still has another 10 years of 10-year government yields under 2%.
As recently as last month, just when it seemed that Japanese yields could not go any lower, they have continued to reach new astonishingly low levels -- 10-year debt fell to 42.5 basis points, beating a previous low from 2003.
Reason No. 5 - Deleveraging has a long way (many years) to go
The McKinsey Global Institute produced a very valuable report ("Debt and deleveraging: Uneven progress on the path to growth") on the extent of the leveraging that took place around the world in the run up to the 2008 crisis. The following table shows the total level of debt (government, household, corporate, financial institutions) in 2008, along with the amount of debt that accumulated in the eight years leading up until 2008, which sowed the seeds of the financial crisis.
(% of GDP), 2008
Change (in %),
Change (in %),
2008 - Q2 12
Source: Debt and deleveraging: The global credit bubble and its economic consequences; McKinsey Global Institute
The important and worrying point to note is that the deleveraging process has barely begun, if at all (except for in the U.S.). The McKinsey report showed how, on a historical basis, a long period of deleveraging has followed a major financial crisis in 32 out of 33 cases since 1930. So, if history of financial crises is a precedent, the deleveraging process, which has hardly started, will create a drag on GDP growth rates for some time to come.
Historical deleveraging periods have been painful, on average lasting six to seven years. But there is reason to argue that this time may be even longer (compared to the historical sample) -- most past episodes involved a local economy or were confined to a region. Today the deleveraging that needs to occur is global in scale, affecting the world's biggest economies.
Reason No. 6 - Inflation not a current threat
Some market commentators argue that the unprecedented "easy money" policies of Central Banks are likely to lead toward higher inflation.
But as this long term graph of inflation shows, there are few current signs that inflation is an imminent concern. The graph shows how core inflation remains firmly constrained around 2% or lower, with few signs of breaking out of its narrow range:
The most commonly cited risk of future inflation is that it will be spurred by the easy money policies of Central Banks around the world.
Indeed, it would be foolish to dismiss the possibility of inflation. But given the levels of inflation right now and the forecasts for growth over the next few years, it seems that inflation is the problem to worry about some time further ahead.
The market certainly agrees with a benign outlook, with 5 and 10-year Breakevens not pricing in the slightest risk of inflation outside the normal historical parameters of close to 2%.
This article has attempted to show how the fundamental factors that have supported the global trends towards lower yields are still in place and are not showing any sign of reversing course. The bond market has enjoyed a strong bull market, and though we may see some corrections, we are unlikely to see meaningfully higher yields in the medium-term.
So where does this leave the investor? Investors need to re-calibrate their expectations of what they can expect from bond returns in their portfolio, with a significant downwards re-adjustment compared to historical norms, and not try to anticipate a rise in yields that may still be several years away.