Bond Markets: Lessons from the US
In the wake of the victory of Donald Trump, financial markets have reacted strongly. As we touched on last week, the focus is on the possibility of a reflationary boost to the US economy, helping growth and raising inflation. As a result, US equity markets have rallied strongly and the dollar is very firm.
Not all markets have performed well. Emerging market assets have, as a group, suffered because of fears of a less favourable outlook for trade and because of the strong dollar. In addition, there have been two significant market developments that should warrant the attention of investors everywhere: one is the weakness of the Chinese currency, the yuan, and the other is the sell-off in US Treasuries. A weaker Chinese currency, if sustained, makes their exports even cheaper, helping keep inflation down across the globe. Meanwhile, the rise in US yields, which means bond prices are falling, feeds a wider debate about whether, finally, we are now witnessing the turning point for bond markets, not only in the US, but globally. It is this issue that I wish to focus on here.
Currently I am in Tokyo, where I have been speaking and participating in a closed doors conference, hosted by the Japanese government, with officials from Japan, and invited participants from here and around the world. (I will focus on the fascinating lessons from here in a separate note). But anyone who thinks interest rates and bond yields globally are about to head significantly higher would be well advised to reflect on what has happened - and is still occurring - here in Japan. At various times in the last two decades Japan has had the very conversation that we are having now in the West: namely, whether this is the end of the bull run for the bond market. Yet it still continues, despite occasional setbacks, here in Japan.
Admittedly, Japan has some unique characteristics. But then every country does. The lesson from Japan that we need to keep asking ourselves is whether there are deep rooted structural issues keeping inflation low, interest rates suppressed and yields down. And if there are, then what is to stop these prevailing in the UK, Europe and the US in coming years just as they have in Japan?
That, in turn, naturally raises the point that it may be premature to suggest the outlook for bonds has changed because of the election of Donald Trump, as important as he is. There is still considerable uncertainty about his likely economic and financial policies. Nonetheless, as the market reaction has shown, his victory has certainly prompted a renewed focus on a number of key economic issues.
One longer term economic factor might have been a consideration for some voters in the US, namely that the growth of 'real' wages (wages after taking out the impact of inflation) have not been rising in some areas, reflecting that economic conditions are different and perhaps less good than they used to be.
Certainly the economic idea of 'secular stagnation', with low wages, low inflation and low productivity is enough of a valid current topic to think that the challenges seen in Japan over the last few decades could be seen elsewhere. And if that is so, then it is certainly premature to suggest bond yields globally are set to soar.
In saying this, the current economic climate around the globe suggests a period of uncertainty for yields, across the government and corporate bond spectrum, led largely by the present debate in the US. Let me highlight both sides of the argument regarding bonds.
Developments in the US over the last week reflect some of the issues in the pessimistic bear market case against bonds. This includes the fact that yields were already too low. In particular, for 10 year US Treasuries, the term premium which is supposed to compensate investors for the extra time they would have to hold longer dated bonds until maturity, was too low and needed to rise. Even after the recent sell off, this term premium is about one per cent below its long term average for 10-year Treasury bonds, suggesting that on this basis they are still expensive. Furthermore, the focus on the President elect's fiscal plans suggests a reflationary policy where the budget deficit and inflation would rise, neither usually being positive for bonds. In turn that would mean that policy rates, currently low, would need to rise.
While all these points are valid, it may be premature to suggest this is the start of a bond market rout. Instead, what we may have seen is an adjustment of positions. After all, the prices for many US bonds are back to where they were at the start of the year.
There is a view that, now that this move has occurred, the US bond market may stabilise. And what happens to US bonds can help influence the tone for markets everywhere.
That is because the rise in yields itself, alongside a stronger dollar, is equivalent to a tightening of policy and this could weigh on US growth in coming months. The market may want to wait and see what actually happens to the new President's policies and to growth before deciding what will happen to bond yields. Indeed, it is not yet clear how much of a fiscal stimulus will be delivered, and while it should boost growth, some investors question this. At the same time there are also worries that aspects of the new President's trade policy could dampen global growth prospects.
Then there is the issue about what happens when the present US economic cycle runs out of steam. That may be a year or two away yet, but if inflation is this low after seven years of growth, what happens when the economy slows? Will some of the similar deflationary pressures evident in Japan over recent years be seen in the US?
All of these are valid points to consider. It helps explain why the US central bank, the Federal Reserve, will still have to weigh up the pros and cons of tightening policy via raising interest rates when they meet in a few weeks. A quarter point interest rate hike in December still seems likely but with so much uncertainty they will proceed with caution.
While this debate is raging most in the US, many of the underlying themes are evident elsewhere, including in the UK. Of course, there is an additional difference, while the Fed is in a tightening mode, the Bank of England has only recently cut - and rightly so, in my view. It also highlights that while there are some dominant global themes, domestic factors also remain key for investors. Indeed, this coming Wednesday 23rd sees the Chancellor's Autumn Statement speech in the UK.
For now, markets everywhere continue to be driven by the aftermath of Donald Trump's victory. It is premature to say this is the start of a bond market sell-off across the board led by the US and to be repeated elsewhere. But as I have outlined here, it is right to be asking these questions. It also provides a useful trigger for investors to reassess the level of risk they are comfortable with. After all, in the present context, market sentiment towards equities appears very positive.
Not all markets have performed well. Emerging market assets have, as a group, suffered because of fears of a less favourable outlook for trade and because of the strong dollar. In addition, there have been two significant market developments that should warrant the attention of investors everywhere: one is the weakness of the Chinese currency, the yuan, and the other is the sell-off in US Treasuries. A weaker Chinese currency, if sustained, makes their exports even cheaper, helping keep inflation down across the globe. Meanwhile, the rise in US yields, which means bond prices are falling, feeds a wider debate about whether, finally, we are now witnessing the turning point for bond markets, not only in the US, but globally. It is this issue that I wish to focus on here.
Currently I am in Tokyo, where I have been speaking and participating in a closed doors conference, hosted by the Japanese government, with officials from Japan, and invited participants from here and around the world. (I will focus on the fascinating lessons from here in a separate note). But anyone who thinks interest rates and bond yields globally are about to head significantly higher would be well advised to reflect on what has happened - and is still occurring - here in Japan. At various times in the last two decades Japan has had the very conversation that we are having now in the West: namely, whether this is the end of the bull run for the bond market. Yet it still continues, despite occasional setbacks, here in Japan.
Admittedly, Japan has some unique characteristics. But then every country does. The lesson from Japan that we need to keep asking ourselves is whether there are deep rooted structural issues keeping inflation low, interest rates suppressed and yields down. And if there are, then what is to stop these prevailing in the UK, Europe and the US in coming years just as they have in Japan?
That, in turn, naturally raises the point that it may be premature to suggest the outlook for bonds has changed because of the election of Donald Trump, as important as he is. There is still considerable uncertainty about his likely economic and financial policies. Nonetheless, as the market reaction has shown, his victory has certainly prompted a renewed focus on a number of key economic issues.
One longer term economic factor might have been a consideration for some voters in the US, namely that the growth of 'real' wages (wages after taking out the impact of inflation) have not been rising in some areas, reflecting that economic conditions are different and perhaps less good than they used to be.
Certainly the economic idea of 'secular stagnation', with low wages, low inflation and low productivity is enough of a valid current topic to think that the challenges seen in Japan over the last few decades could be seen elsewhere. And if that is so, then it is certainly premature to suggest bond yields globally are set to soar.
In saying this, the current economic climate around the globe suggests a period of uncertainty for yields, across the government and corporate bond spectrum, led largely by the present debate in the US. Let me highlight both sides of the argument regarding bonds.
Developments in the US over the last week reflect some of the issues in the pessimistic bear market case against bonds. This includes the fact that yields were already too low. In particular, for 10 year US Treasuries, the term premium which is supposed to compensate investors for the extra time they would have to hold longer dated bonds until maturity, was too low and needed to rise. Even after the recent sell off, this term premium is about one per cent below its long term average for 10-year Treasury bonds, suggesting that on this basis they are still expensive. Furthermore, the focus on the President elect's fiscal plans suggests a reflationary policy where the budget deficit and inflation would rise, neither usually being positive for bonds. In turn that would mean that policy rates, currently low, would need to rise.
While all these points are valid, it may be premature to suggest this is the start of a bond market rout. Instead, what we may have seen is an adjustment of positions. After all, the prices for many US bonds are back to where they were at the start of the year.
There is a view that, now that this move has occurred, the US bond market may stabilise. And what happens to US bonds can help influence the tone for markets everywhere.
That is because the rise in yields itself, alongside a stronger dollar, is equivalent to a tightening of policy and this could weigh on US growth in coming months. The market may want to wait and see what actually happens to the new President's policies and to growth before deciding what will happen to bond yields. Indeed, it is not yet clear how much of a fiscal stimulus will be delivered, and while it should boost growth, some investors question this. At the same time there are also worries that aspects of the new President's trade policy could dampen global growth prospects.
Then there is the issue about what happens when the present US economic cycle runs out of steam. That may be a year or two away yet, but if inflation is this low after seven years of growth, what happens when the economy slows? Will some of the similar deflationary pressures evident in Japan over recent years be seen in the US?
All of these are valid points to consider. It helps explain why the US central bank, the Federal Reserve, will still have to weigh up the pros and cons of tightening policy via raising interest rates when they meet in a few weeks. A quarter point interest rate hike in December still seems likely but with so much uncertainty they will proceed with caution.
While this debate is raging most in the US, many of the underlying themes are evident elsewhere, including in the UK. Of course, there is an additional difference, while the Fed is in a tightening mode, the Bank of England has only recently cut - and rightly so, in my view. It also highlights that while there are some dominant global themes, domestic factors also remain key for investors. Indeed, this coming Wednesday 23rd sees the Chancellor's Autumn Statement speech in the UK.
For now, markets everywhere continue to be driven by the aftermath of Donald Trump's victory. It is premature to say this is the start of a bond market sell-off across the board led by the US and to be repeated elsewhere. But as I have outlined here, it is right to be asking these questions. It also provides a useful trigger for investors to reassess the level of risk they are comfortable with. After all, in the present context, market sentiment towards equities appears very positive.
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