The Bond Market Conundrum

Aug. 08, 2018 12:11 AM ETIEF, PST, IEI, VGIT, UST, DTYS, TYO, GSY, SCHR, TBX, TYD, SPTI, DTYL, HYDD, DFVL, TYNS, DFVS5 Comments
John Derrick, CFA profile picture
John Derrick, CFA
110 Followers

Summary

  • Calls for 5% 10-year treasury yields are hyperbole and out of touch with current dynamics.
  • Inflation risks are to the downside despite the strong economy.
  • It is time to be bullish on bonds, not bearish.

Over the weekend, JPMorgan’s (JPM) CEO Jamie Dimon was quoted as saying he believed 10-year treasury yields should be 4% and warned that 5% is a definite possibility that investors need to prepare for.

When the CEO of one of the largest banks and brokerage firms in the country makes such a strong statement about the direction of bond yields, investors take notice. Mr. Dimon had previously commented that the “natural rate” for the ten-year bond should be 4%, presumably composed of 2% inflation and a 2% “real” rate above and beyond inflation. With 10-year treasuries hovering just below 3%, and using a 2% real rate as sufficient return for taking the risk of holding a 10-year security, implies the market is effectively pricing in roughly 1% inflation over the next decade.

The U.S. treasury market doesn’t operate in isolation and global government bond yields remain historically very low. This is largely driven by stubbornly low inflation around the world, despite the attempts of global central bankers to reignite inflation. I have included a chart of various global bond yields, the developed markets in this graph yield significantly less than U.S. treasuries and even Chinese 10-year yields are only around 3.5%.

Source: Thomson Reuters

If the U.S. 10-year immediately rose to 4%, it would yield more than the equivalent Chinese 10-year and dramatically more than other developed markets. This doesn’t make sense to me, unless the U.S. was on the verge of a dramatic spike in inflation, which seems very unlikely.

For example, for most of the past 25 years, core consumer prices (CPI ex-food and energy) have consistently oscillated around the 2% level. This low level of inflation seems to surprise most investors, who mistakenly believed inflation was considerably higher for most of this period.

Source: Thomson Reuters

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This article was written by

John Derrick, CFA profile picture
110 Followers
I have 18 years’ experience as an institutional portfolio manager and 25 years in the investment management industry. In a wide-ranging investment career, I have managed a wide variety of mutual funds, including money market funds, municipal bond funds, U.S equity and emerging market equity funds. I have also had portfolio management responsibilities for a U.S. equity and an international equity separately managed account (SMA). This diverse background gives me a somewhat unique perspective on opportunity and risk.

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.

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