Is the bond market at a similar point as it was in the mid to late 1940s? We are going to look at the U.S bond market in the late 40s versus the current bond market conditions to determine whether we are heading into a period of ever increasing yields or not which will answer the question of will history repeat itself.
What happened to yields in the late 1940s?
My main focus with yields is going to be regarding the ten-year Treasury. For the graph below the shaded areas represent a recession.
Rates were capped at 2.5% during much of the 1940s. Rates stayed under 2.5% even after the cap was no longer in effect. Yields didn't hit 3% until 1953. After an additional six years, yields hit 4%.
What happened to yields coming out of quantitative easing in the 1940s versus what I think will happen going forward is what we are looking at. The two time periods seem very similar, but when you look at the finer details of the two there are differences that may answer my question. One of the biggest similarities is Fed holdings as a percentage of GDP. Around 1941 it peaked at about 23% and the peak recently was at about 24%, which occurred at the end of 2014 subsequently around the time the Fed ceased the expansion of their holdings. That figure has since declined to just fewer than 23%, which is mainly a function of GDP increasing and holdings staying constant due to the fact that still as of September 2016 the Fed is continuing to reinvest principal from maturing securities with buying focused mainly in the two- to ten- year space.
As Treasuries mature and subsequently reinvest over time that will continue to provide a ceiling on intermediate to long-term rates, especially on the long term end due to the fact that as of the end of 2015 the weighted average maturity of the Fed's holdings was 8.7 years, so there is a focus on the longer end of the buying focus range.
Another factor putting a ceiling on long-term interest rates is the Fed plans on unwinding their holdings in a gradual manner by eventually ceasing reinvestment of maturing securities and no plans on selling longer-term securities. Notice how the graph below has been flat since late 2014 and the shaded grey area on the left indications of a recession.
Now onto differences.
In the late 1940s, the Fed held mostly T-bills rather than longer-term bonds like now a days and part of their policy over the next couple of decades was to sell long-term securities and buy T-bills instead. That policy encouraged long-term rates to rise over time as the bonds were being sold.
It is one of the biggest differences between the two time periods. After WW2 inflation started to rise and even hit a monthly high of almost twenty percent! Relatively high inflation levels continued until the early 1950s then began to level out and stay in the low single-digits. Now to take a look at the U.S. over the past couple of years, inflation doesn't seem to be a huge worry at least for the time being. High levels of inflation were/are a concern as a result of the current accommodative monetary policy environment that we have been in for the past eight years, but so far hasn't come to fruition. Inflation in the 1940s was a main factor that caused the Fed to abandon the low interest rate environment peg as a way to help rein in inflation. With inflation not being a concern the Fed won't have to raise rates sooner than they would like. A final difference to consider is that in the 1940s rates were held low to help fund the war at low rates and today rates are/were low to help facilitate an economic recovery.
After reviewing the data I believe we are going to see a similar pattern of a rise in yields as what was realized in the late 40s and throughout the 50s, but to a lesser degree. The main reasons for my outlook are the Fed no longer expanding their holdings, the differences in inflation rates, and the eventual ceasing of reinvestment of maturing treasuries. Although I expect yields to rise over the intermediate to long term I don't think we will see a 3% yield on a ten-year Treasury for quite some time, so no severe/drastic bear market on the horizon. Even in the face of increasing yields bonds still play an important role in portfolios, as a good diversifier and source of income that shouldn't be ignored.
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