Are we in a bear market for bonds? And if so, what does this mean? The start of the year has begun much as 2017 finished: with generally positive economic data across the globe, and in turn more optimism about the outlook; a strong performance by equity markets that has fed the ongoing debate about whether a major correction is due; and a debate in the US about whether the outlook for bond markets has turned from a bull to a bear market?
While all these issues are interlinked, it is the latter that we address here. A bear market would imply the longer-term direction of bond yields has changed. Since the latter half of the 1980s we have witnessed a global bull market for bonds, whereby the general direction of yields has been down. This has largely been driven by the change in the inflation environment seen over this period: where we have moved to sustained low inflation – and in turn expectations of future inflation have changed dramatically with markets, savers and investors factoring in continued low inflation.
But even in a bull market, where the trend was for yields to decline, there were some painful sell-offs when yields rose for a prolonged time, sometimes six months, occasionally a year, before resuming their downward path. This can be seen in chart one, which shows 10-year gilt yields since the beginning of 1990: a downward trend with some reversals along the way.
In the US there has recently been a significant rise in longer-dated yields, driven by a combination of factors including tighter monetary policy as the Federal Reserve raises rates further and shrinks its balance sheet. It’s worth noting, however, that while US yields are now above levels of the last couple of years, they are still trading below their levels of 2014. The rise in yields has not been mirrored here, where gilt yields have stayed low. As a result, US yields are at their largest spread above gilts for some time, as shown in chart two.
Chart two shows 10-year US Treasury yields minus 10-year gilt yields. So a positive figure, which is where we are now, has US Treasuries yielding far more than UK gilts. This is an unusual situation by historical standards. This begs the question, what lies ahead for gilt yields? While there are global spillovers and market sentiment may be impacted by trends in the US, domestic factors are also key.
Key issues for savers and investors
There are two key issues for savers and investors: one is the direction of yields; the other is the shape of the yield curve, which is usually referred to in the context of the difference between two-year yields (the short end of the curve) and 10-year yields (the long end of the curve). Currently this is upward sloping, as two years yield 0.55% and 10 years 1.30%.
In our view this may flatten in coming years, as yields at the short end rise by more than those at the long end. This is because we expect the Bank of England to raise official rates gradually, pushing short-term yields up. But we expect inflation to stay subdued, keeping long-term yields low, although higher than they are now.
Assessing the five-year rate
One of the multitude of figures we keep an eye on is the five-year five-year forward rate. This is what the market expects five-year yields to be in five years’ time – one benchmark by which to gauge expectations. It shows that before the financial crisis this level averaged between 4% and 5.5%. Now it hovers nearer 2%. This seems justified now but not in coming years if growth is steady and interest rates rise to keep inflation in check.
If you believe inflation will be around the Bank of England’s 2% target and growth near the 1.5% widely being assumed as the likely future trend, then adding these two together to give nominal growth of 3.5% would seem a reasonable guide to what might in future be termed neutral 10-year yields. So, higher than now, but not aggressively so. The returns in this environment would be lower than what investors are used to, but would only cause damaging losses if yields move in a disorderly fashion.
Of course, when markets adjust they can often overshoot before stabilising – say a bit like sterling against the dollar over the last 18 months. So, in this case, if yields were to rise they could always overshoot.
The upshot: a number of indicators to monitor
Let’s consider inflation expectations. If you think inflation to be a genuine risk you best avoid gilts altogether, as it would likely force the Bank of England to raise rates significantly and also force bond yields up. The latest data shows inflation eased to 3% in December, consistent with our outlook and the market’s view that inflation has peaked. We expect it to decelerate towards 2% by year-end. Thereafter, we expect inflation to be subdued but there is no doubt that there are greater inflation risks than before – given the tight labour market and little spare capacity in the economy. So, this inflation risk cannot be ignored and must be monitored.
Much then depends upon growth. The market is cautious – perhaps overly so – about future growth. It may yet prove to be still nearer 2% but requires more investment to get there. Given uncertainty over Brexit the market may need to be convinced about growth prospects.
There are other key influencers. These include the term premia, which is the reward for holding longer-dated debt as so much could change the further ahead one looks. Demand and supply dynamics for bonds also matter. The UK debt management office should be congratulated for how the maturity of UK debt is so long compared with other countries, around 14 years average maturity for us, whereas low single digits for many others. Indeed the structure of UK institutional market ensures that there is strong demand for long-term debt from insurers and defined benefit pension funds alike. These are stabilising influences.
Risk premium and the idea of a flight to quality matters, too. If the market is nervous about geopolitics, economic risks or even that the equity market could correct significantly then this will help gilts, perhaps more so at the shorter end of the yield curve. There is perhaps an element of this already. Also, the budget deficit could fall faster than expected if nominal growth proves to be around 4% to 4.5% this year (growth of 2% and inflation averaging around 2.5%) and yields stay low.
Finally, there is Bank of England policy. Perhaps this is the key factor this year. The Bank should take into account the issues mentioned here – and more, such as productivity, highlighted by the latest speech by a Monetary Policy Committee rate-setter this week.
The UK requires a rebalancing of policy. I have favoured a more relaxed fiscal stance. We seem to be moving towards that. As for monetary policy itself, the Bank looks set to tighten further, and gradually, this year. We expect two quarter point hikes. The pace at which that happens will be a key determinant of the pace of the upward trend for bond yields. Yields may head higher but it may be premature to call it a bear market.