Tuesday, May 5, 2015

We're in the early stages of a new bond bear market

I'm crazy to do this, but it sure looks like the Great Bond Bull Market has ended and we are in the early stages of another bond bear market. 

The Great Bond Bull Market started in the fourth quarter of 1981, after the 10-yr Treasury yield hit an all-time of almost 16%, and about a year after the year-over-year change in the CPI hit a post-Depression high of almost 15%. It most likely ended 31 years later, in July 2012, when the 10-yr yield fell to 1.4% at the height of the PIIGS crisis, and three years after the CPI hit a post-Depression low of -2.1%.

As the chart above shows, inflation is arguably the principal driver of yields.

By the way, the first bond bear market of the current century started in 1950 and also lasted 31 years. The bear market that is now beginning to unfold will undoubtedly also be many years in the making, and we can only guess at how much yields will eventually rise. I certainly hope they never get as high as they did in the early 1980s, and I don't expect they will.

What prompted me to make this call? It was the recent 47 bps bounce in 10-year German bund yields, off of an incredible low of 0.05% a few weeks ago. Germany, not Japan, can now lay claim to the lowest 10-yr bond yields in history. As the chart above shows, U.S. and German 10-yr yields  have been tracking each other pretty closely for a long time, but they diverged significantly over the past year or so. Last month the difference between the two hit an all-time high of 190 bps; German bunds were in the grip of a buying panic, spurred in no small part by intense fears of a Greek default and also by fears of deflation, that subsequently evaporated (a Grexit needn't be an earth-shattering event, and oil prices are up over 30% in the past three months). Since conditions in Europe are not significantly worse than in the U.S., we'll probably see the gap between U.S. and German yields narrow, with German yields rising more than U.S. yields over time. Welcome also to a new German bond bear market.

So here's the big question: does a new bond bear market also mean an equity bear market? My answer: not necessarily, and most likely no. For the next few years, yields are likely to rise only to the extent that economic optimism and nominal GDP expectations rise. Rising yields will be the result of stronger nominal growth, not the nemesis of stronger growth. Besides, the U.S. economy has plenty of room to grow, as I argued last week.

The time to worry about rising yields is when the Fed is tightening and the yield curve is flattening. The two charts above help explain this. In the first, we see that recessions are preceded by a Fed tightening which lifts the real Fed funds rate above the level of 5-yr real TIPS yields (i.e., an inversion of the real yield curve). We see the same story with nominal yields in the second chart: recessions typically follow a period in which short-term interest rates rise enough to equal or exceed long-term rates. Currently, we are probably years away from either of these events happening. The Fed is still extraordinarily accommodative, since real short-term yields are decidedly negative, and they have all but assured us that they will move slowly to tighten. The chart below sums it up: every recession in the past 50 years has been preceded by real short-term rates of at least 3% and a flat or inverted yield curve. Considering that core inflation is currently running about 1.5%, the threat of unpleasantly tight money is at least several years in future.


PittsburghDog said...

Everything you wrote makes perfect sense, but I would be willing to bet given the current fed environment that the next recession will happen prior to real short-term rates reaching 3%. I believe the 1yr - 10yr slope will be the more accurate of the two indicators.

Scott Grannis said...

I expect I'll be checking back on this post quite a few times in coming years, either because I was eerily right or exceptionally wrong.

Benjamin Cole said...

Brave call, sound reasoning. Now, will markets agree?

Japan never got out of ZLB. The ECB is struggling.

A fascinating market to watch. I sense central banks have yet to adjust to new realities---maybe yields go down from here.

Benjamin Cole said...

"10 Year Treasury Rate is at 2.16%, compared to 2.12% the previous market day and 2.60% last year (a year ago). This is lower than the long term average of 6.45%."


Yes, I know there are fancy ways to measure inflation expectations.

But when institutional investors will lend money for 10 years for 2.16%, really, what are inflation expectations? I would say inflation expectations are near zero, and for a longish horizon.

Or...the market is betting on ever lower yields.

Or...the CPI overstates the true rate of inflation, by 2% or so. This makes sense actually.

Benjamin Cole said...

I just read in The Economist there is $12 trillion in deposits or money market funds in US, earning about 0% interest.
How can rates go up? Money is everywhere. There are new Niagaras of capital adding to the pot.
Supply and demand.

William McKibbin said...

I seriously doubt that the Fed will allow bonds to fall into a bear market. Let's face it, the Fed will shore up bonds regardless of the impact on the rest of the economy. My guess is that the Fed will protect its borrowing regimes even if that means disease, famine, war, and death across America. In the final analysis, the Fed always gets what the Fed wants, and that means bonds will be protected at all costs.

William said...

Scott, You're in good company as Bill Gross recently wrote: "Stanley Druckenmiller, George Soros, Ray Dalio, Jeremy Grantham, among others have warned investors that our 35 year investment supercycle may be exhausted."

Here is a link to Bill Gross' Investment Outlook (5/4/2015): "A Sense of an Ending"


Benjamin Cole said...

William---for 35 years, central banks fought inflation and brought rates down.
The next supercycle could be even better---if central banks adjust to new reality.

Ausgarry said...

Thanks William - interesting philosophical Goss piece. Pardon my ignorance but is it generally accepted that there has been a 35 year supercycle and is it thought to apply to all asset classes?

William said...

@ Ausgarry

I don't know if it is generally accepted. John Train the author of Preserving Capital and Making it Grow - an admired book from 1982 - wrote about the cycles of rising and falling interest rates which historically were about 15 + or - a couple years.

The reason Bill Gross refers to the recent 35 years of falling interest rates as a supercycle is because it is more than twice as long as the typical 15 year cycle.

You should read Gross' entire article to understand his points about how the future earnings of all assets are "discounted" to the ten year bond yield to estimate their appropriate present values. When an equity analyst is discounting a stock to 1% or 0% or a negative number, how much higher could equity prices possibly go?

An investor needs to understand how unique the present global economic situation is - unprecedented is not a strong enough word to describe it.

Benjamin Cole said...

William---There was a lot of prosperity in Europe, Japan and the US post WWII, with rising rates. More than now, in terms of GDP growth.
The world's central banks need to become growth oriented. They are independent public agencies, a recipe for ossification. Can they change? Big question.

Benjamin Cole said...

Ooof. Now they say Q1 GDP could be negative.

Feeble job numbers too.

William McKibbin said...

Anyone still dreaming about a US recovery lead by industry should consider this chart:


The days of industrial growth are over...

sgt.red.blue.red said...

I think the long end will approach the short end, before they have to raise the short rates much. Slow growth environment. Europe isn't going to charge ahead much. Too much structural cholesterol. The U.S. has just been shufflin' along for six years. Don't see that changing much.

But, I'll add your caveat, Scott.

WilliamHeadley said...
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