How far can bond yields rise?
The election of Donald Trump to the US Presidency has been blamed (quite rightly) for the spike in global bond yields over the past week, and the further trashing of what was once considered “defensive yield” sectors such as listed property and infrastructure.
But the reality is that global bond yields have been edging higher for several months already, even when it was though that Hillary Clinton was a shoo-in for the White House. We can’t just blame The Donald.
Indeed, as seen in the chart below, US 10-year Treasury bond yields have been rising since touching a low of 1.37% in early July in the wake of the UK’s Brexit decision. That’s even lower than during the depths of the global financial crisis in 2008, and the European financial crisis of 2012.
The latest rebound in yields clearly reflected the realisation that the world did not end when the UK (which, after all, accounts for a mere 2.5% of the global economy) decided to leave the European Union. Associated with this, the Bank of Japan and the European Central Bank have reconsidered their path toward further aggressive monetary easing, particularly as it now seems clear this would more hurt than help the ability of their banking sectors to extend further credit.
Last but not least, higher bond yields have reflected the realisation that the US economy continues to motor along, with a tightening labour market and rising labour costs. The market is pricing a near-certain probability that the Fed will hike rates next month and signal at least two further rates rises next year.
Of course, all this begs the question: how far can bond yields rise?
The most celebrated bond market sell-off was in 1994, when US 10-year bond yields rose 2.8 percentage points within a year to a peak of 8%. But as seen in the chart above, there have also been other bond market sell-offs since then, typically associated with an unwinding of fears concerning one financial crisis or another. Following the 2008 financial crisis, US 10-year yields rose by around 2 percentage points, and following the European financial crisis, by around 1.6 percentage points.
If the average of the last two bond sell-offs takes place over the coming year, it would push 10-year yields up another percentage point to around 3.25%.
Also noteworthy is that, unlike in previous bond yield cycles, the recent bottom in yields was quite close to the bottom in 2012 – a tentative sign that the trend decline in yields over recent decades may be finally bottoming out. Should 10-year yields push much above 3% - taking out the previous cycle high in 2013 – it would be further confirmation of the death of the multi-decade bond bull market.
Of course, there a good grounds to think that bond yields should not need to stay abnormally low. Though many commentators continue to bemoan allegedly weak global growth and low inflation, the fact remains that economic growth across much of the developed world has actually been above potential in recent years, with rates of unemployment falling. Weak wage growth is partly a result of weak productivity: indeed, as the Reserve Bank recently pointed out, unit labour costs in both Japan and the United States have been growing at “above average” rates.
And it may surprise some to know that global inflation indicators are also not unusually low. Core inflation in the US, in particular, is only just under the Fed’s 2% inflation target and close to its long-run average. Long-term economist inflation forecasts have hardly budged during the alleged “deflation scare” of recent years.
All up, baring a lurch back into recession by the US economy in 2017, further gains in bond yields – taking, for example, US 10-year yields back to at least around 3% - seems likely, which will continue to pressure the performance of former “defensive yield” darlings of the equity market.
Investors might instead start to focus on sectors that may benefit from higher bond yields, such as the global banks (exposure to which is possible on the ASX through the BNKS ETF). Even the local banking sector might benefit to the extent valuations have already been beaten down and their performance will be less hurt by rising bond yields than that of, say, listed property.
Published: Wednesday, November 16, 2016
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