Eran Peleg, CIO
Higher Bond Yields: Are We There Yet
Eran Peleg, CIO December 19, 2016
First some illustration from the Simpsons:
Bond yields have risen recently on the back of increased growth, inflation and interest rate expectations. The benchmark 10-year US Treasury bond yield has shot up to 2.59% from as low as 1.37% in July. Around a third of this move, up to around 1.8% yield, was an unwinding of the overbought conditions that prevailed after the June-end Brexit vote when investor fear drove up prices of safe-haven assets. However, the remaining two-thirds (from 1.8% to around 2.6%) occurred after the US elections – as investors assigned higher probabilities to stronger future growth (and inflation) due mainly to expectations that the new US administration will stimulate growth by fiscal measures (infrastructure spending and lower corporate tax rates). This, in turn, impacted interest rate expectations, which were then even further boosted by the Federal Reserve's December rate increase and the accompanying Fed forecasts for additional three (rather than the previously-assumed, two) rate hikes in 2017.
Given the extent of the rise in bond yields, some commentators are now calling for the end of the bond bear move and suggesting it may be time to jump in and buy bonds at higher yields.
We did see a quick and violent move in a short period of time, and bonds may be oversold in the short-term. However, history suggests that bond yields could see continued upward pressure. First, even at higher yields, high-quality bonds still offer meager real returns to investors going forward. For example, the 5-year US Treasury is now yielding 2.07%. There is not much margin of safety in this (nominal) yield to ensure that investors will be earning a positive real (inflation-adjusted) return if the bond is bought and held to maturity. But second, although interest rates probably will not rise as high as they have in previous cycles (due to structural economic reasons), there is still a fair chance that investors, whose expectations are usually biased by their recent-past experiences, are currently underestimating the potential for interest rates to rise in the US. If this is the case, we could see bond yields rise further. Actually, this is normally what happens in major turning points in the interest rate cycle. In 1994-1995, they initially expected around 125 bps of tightening (Fed Funds Rate), and within 12 months they got 300 bps. In 1999-2000, they were looking for 75 bps, and got 175 bps. In 2004-2005, they were much closer, but were still surprised. Each cycle is obviously different in its characteristics and dynamics (and Fed communication has improved over time) – but each time, investors get it wrong. Are we there yet? Possibly not.
Disclaimer: Nothing contained herein is investment advice and one should consult with a professional about their investment situation before they make any investment decisions.