Carnage In The Bond World? Nope! Long-Term Trend Still Intact

by: Matthew Salter, CFA

Summary

The multi-decade-long bond bull market can lull investors into thinking that markets move in only one direction.

The recent correction in yields is 'normal' in the context of previous corrections within the overall trend.

Even with the overall trend intact, we could see an extended period of time with higher yields than those we have seen in recent years.

Carnage in the bond world? Nope! Long-term trend still intact.

There have undoubtedly been some recent major shocks running through the normally sedate US government bond world, which have had knock-on effects into non-government bonds and global bonds.

This article aims to put these shocks into historical perspective. By doing so, we can help to frame the latest changes in yields in a longer-term context to understand whether the magnitude of the moves signals a change in trend, or a correction with the overall trend still intact.

Long-term trend

Let's start with the long-term trend, which as we see from this chart of the yield of the 10-year US Government Treasury bond, has been pretty clearly in one direction for the last twenty five years or so.

Source: US Treasury Department

But we can also see in the latest increase in yields that a fairly significant correction has evolved over the last few weeks. It is certainly the largest rise in yields over the last three years, but in the historical context it is not (yet) a correction that marks an end to the trend and the world of low yields.

(It is also worth noting that it was not the result of the US election that proved to be the trigger for the upward correction in yields. Yields bottomed out at about 1.35% in July, and on the day before the election has already risen 50 basis points or so to 1.88%. So in fact, the increase in yields on the US Treasury have been about the same post-election as they were before election. Trump can be blamed for a lot of things, I am sure, but yields were already heading up before his election success).

As I have pointed out in a previous article (see here), long-term trends - even one of this magnitude (i.e. a 25-plus years long bull market) - are by no means one-way traffic.

It is interesting that even though the article referenced in the previous paragraph was written almost four years ago, it was addressing a similar major concern in the financial world at the time, which was whether the multi-year downward trend was about to change - was the bond bubble about to burst?

My conclusion then was a quite adamant "NO," we were not witnessing the end of the bond bubble. And though it is always nice to get a pat on the back for being correct, the interesting thing is how many people were predicting the end of low yields all that time ago.

So, given the more recent moves we have seen in the bond markets, the question is whether the answer remains the same - that is "no, we have not yet seen the end in the long term trend"?

It is interesting to look again at some of the 'amazing' facts I highlighted in the original article and to refresh them in light of the recent moves in the bond market.

Despite the strength and clear trend of the bull market, the fact is that in a staggering 47% of months (measured as month-end to month-end), yields have actually risen. That is to say that within any given month over the last 25 years, you would have been pretty much as likely to see yields go down as to have seen them go up.

The following chart shows the monthly changes since 1990 in the yield of the 10-year Treasury, on a month-end to month-end basis.

Source: Federal Reserve, own calculations

A few interesting things to note about the current increase in yields:

  • Yields have now increased by about 100 basis points since their lows in July of this year. That is still less than the increase in yields which we saw at the time of the last major correction in 2013, when yields increased by over 150 basis points to over 3% before then resuming their downtrend.
  • Yields have now increased for four consecutive months (measured on a month-end to month-end basis). Again, this isn't so unusual - the 2013 correction also saw four months of consecutive increases in yields and not long before that in 2010-11 the market saw five consecutive months of increasing yields.
  • What is unusual, as we can see from the chart above, is that a one-month increase in yields of over 50 basis points, does not happen very often. In fact the last time a monthly change of this magnitude occurred was almost seven years ago on the tail-end of the market reaction that followed the global financial crisis.

So what we have seen is that, yes, the change in yields over the last few weeks and months has been fairly significant. But within a longer term historical context, the moves are not unusual when judged alongside previous corrections.

Another fact that points to this being an orderly re-pricing and not the bond carnage that some headlines have made out, is the fact that some parts of the bond market have hardly felt even the slightest tremor from the recent increase in yields. In fact, the further down the credit curve the investor was placed, the less affected they have been by the increase in yields in the safest part of the bond world (i.e. US Treasuries).

The following table compares the returns from various BofA Merrill Lynch total return bond indices:

Index

Latest drawdown

Return Year to Date

US Corp AAA

-6.54%

2.76%

US Corp Investment Grade

-3.90%

5.30%

US High Yield

-1.32%

15.22%

Source: Federal Reserve, own calculations

Investors in High Yield bonds who slept through November would have looked at their returns this weekend and had no idea that the financial press had been talking about a bond meltdown.

This has been driven by two main factors - i) the high yield bonds have had enough of a yield 'cushion' to protect the investor from the increase in yields, ii) the increase in yield of 'safe' Government treasuries has not seen a widening in spreads i.e. the market has not been alarmed at the prospect of any increased credit risk and the increase in government bond yields has not in truth triggered any real carnage at all further down the credit curve.

Conclusion

The recent increase in yields in the US Government bond market has been a wake-up call to complacent investors who assume trends will always continue in one direction.

But the jury is still out on whether the correction is just that, a correction, or will materialize into a new longer term trend towards much higher yields.

Given the scale and scope of the correction so far, and put in a historical context, I would still remain bullish on the longer-term trend in bonds - the main factors that have driven yields so low (including low growth and high debt) are still in place.

But this viewpoint does not contradict with preparing strategically for a lengthy period of higher yields than we have become used to over the last few years. Within the decades-long downward trend in yields, corrections have taken place that have historically played themselves out over many months, if not years. A number of factors are coming into play (including Trump spending policies, low unemployment and higher inflation) that indicate that yields could correct higher still at this point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.