Bond boom’s over as central banks end QE
Investors prefer stocks as economies improve worldwide
Investors are dragging their attention away from the stockmarket for a moment to figure out what is going on in the other main part of their portfolios: government bonds. Yields have been rising so far this year and Bill Gross, one of the sector’s gurus, has said the long bull market (which dates back to the early 1980s) is finally over.
This certainly seems to be the month for big calls; the noted equity bear Jeremy Grantham has already pointed to the potential for a “melt-up” in the stockmarket. Gross, who runs money for Janus but made his name at Pimco, said that the 25-year trend lines had been broken for both the five- and 10-year bonds.
The end of the bond bull market has been called many times, dating back at least to September 2011. There is something profoundly unsatisfying about bond yields of 2 per cent or so; they seem to offer a dismal reward. An old saying about British investors is that “John Bull will stand anything but not 2 per cent”.
Gross’s pessimism about government bonds is widely shared; a net 83 per cent of fund managers polled by Bank of America Merrill Lynch think bonds are overvalued while a net 59 per cent are underweight the asset class.
Such widespread pessimism is normally a contrarian indicator. If everyone is already underweight, who is there left to sell? But the bond market has changed a lot since the financial crisis.
The massive expansion of central bank balance sheets via quantitative easing has altered the balance of supply and demand.
Central banks intervened to drive down bond yields and they duly fell.
It is hard to be precise about how much the fall in yields was down to central bank actions. Low inflation and pessimism about the prospects for long-term economic growth (the secular stagnation debate) played a big part; of course, those factors also explain why central banks were intervening.
Many people have long feared what would happen when central banks started to unwind their bond purchases, which total trillions of dollars. Those worries help explain why the central banks have been so cautious about policy changes. Back in 2013, when the Federal Reserve started to reduce its bond buying, an episode known as the “taper tantrum” eventually pushed 10-year bond yields to 3 per cent; for context, they are now 2.58 per cent. But even through the Fed eventually stopped buying, the European Central Bank and the Bank of Japan were still willing purchasers.
One reason for the bond sell-off now is worries about what those two central banks might do. The ECB has cut its monthly bond purchases from €60bn ($92bn) to €30bn, and as the eurozone economy strengthens, might be tempted to stop altogether in September.
The Bank of Japan has this week cut the size of its bond-buying, although it is not clear yet whether this is a permanent shift of policy.
An extra layer of worry is that China may be slowing its purchases of American treasury bonds; these are bought not for QE purposes but because China has to do something with its foreign exchange reserves. (It is scarcely surprising that the Chinese might be worried about investing so much of their wealth in low-yielding assets in a currency they can’t control and backing a government run by the unpredictable President Trump. Some analysts are interpreting the Chinese moves as a “shot across the bows” to the US ahead of potential trade sanctions.)
There is a clear link between these concerns and the optimism about the global economy that is driving stockmarkets higher. In a faster-growing economy, investors would rather own equities than bonds; furthermore, a fastergrowing economy has less need for government support. The optimistic view is that this could be a relay race in which central banks are finally able to hand over the baton for growth-supporting policies to governments (that is, the Trump tax cuts) and the corporate sector.
All this creates a good case for sending bond yields a bit higher. But for them to go a lot higher re- quires the return of inflation which is still hard to spot. Nor do investors seem to expect it any time soon. The St Louis Fed monitors expectations for inflation five years out; the forecast is currently 2.13 per cent. That is below its level of April last year and well below expectations back in 2013 and 2014.
It is worth recalling that, only a few weeks ago, some commentators worried that a flattening yield curve (short-term rates closing the gap with long-term yields) was a sign of a slowing economy. And the markets are littered with the failed careers of those who bet that ultra-low Japanese bond yields would not last — a trade known as “the widow-maker”. Ten-year Japanese yields are 0.08 per cent. A very sharp rise in bond yields would alarm the central banks and prompt more monetary easing (or at least an end to tightening).
Another way of looking at the 10-year bond yield is to see it as the summary of expectations for the future trend in short rates. Do you really believe that the Fed can push short rates up to 3 per cent and beyond?
That is putting rather a lot of trust in the Trump program. Fourth quarter growth may have been an annualised 2.7 per cent, which is not bad. But with the oil price rising, the Fed stepping on the brakes and the labour market getting tighter, how long can this carry on?
It is one thing to say that bond yields may be heading to the top of their recent range. That is a long way from “bondmageddon”.
The Bank of Japan trimmed the size of its bond-buying program this week
Bond market guru Bill Gross