In the middle of 2016, developed country bond yields fell to their lowest levels ever – in hundreds of years. Bonds were in a bubble. How else can you describe the certain prospect of ultra-low or even negative yields? Since then yields have spiked, prices have plummeted, and bond investors have had a shock. Is the bond bubble bursting? Or is it just taking a pause before the final blow-off top?
For most of the last 35 years it’s made sense to own high grade government bonds. Yields fell, prices rose, returns were comfortably above inflation, and bonds offered a nice portfolio diversifier against periodic stock market crashes.
The end result has been a bubble, at least partly caused by central bank manipulation of markets. In the US, Japan, UK and eurozone – to name the main culprits – trillions of dollars worth of money has been printed to prop up bond prices and suppress yields (so-called “quantitative easing”, or QE). This amounts to central planning of which the Soviets would have been proud.
To get a sense of how big this bubble is, let’s look at some charts of bond yields. Remember, when it comes to bonds, as yields fall prices rise, and vice versa.
I’ll start with my favourite, which shows Dutch 10 year bond yields going back to 1517. Yes folks, that’s just a few weeks short of 500 years of data, courtesy of Deutsche Bank’s Long-Term Asset Return Study.
The Netherlands is interesting because it’s the longest data set. But other countries show a similar picture. Here’s the US 10 year treasury yield, although it “only” goes back to 1790, a mere 226 years.
It’s a similar picture in pretty much all the developed countries of the world. Yields recently touched their lowest levels in hundreds of years. As some market wit has put it, “risk-free return” has morphed into “return-free risk”.
Governments can always print money to pay off their debts. It’s just that you won’t make a decent return for lending to them, and the money could be worth a lot less by the time you get it back.
That’s the really big picture – the broad sweep. What about in more recent times? By that I mean since the early 1980s, over the last generation – and certainly longer than the professional careers of most bond traders and investors.
Here’s what happened to US 10 year treasury yields since 1980…
Here are 10 year German government bonds (known as “bunds”)…
And 10 year Japanese government bonds (JGBs) since the mid ‘80s…
And Swiss government bonds since the mid ‘90s…
Last, but not least, UK 10 year government bonds (known as “gilts”) since 1980…
The pattern is the same in all cases. Yields have collapsed and bond prices have rocketed, if not in a dead straight line.
But in the past few months yields have taken a sharp reversal. Bond prices have fallen hard as a result. We can see this by looking at various bond ETFs (exchange traded funds). I’ve chosen these government bond ETFs to illustrate:
- iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT); priced in US dollars; average maturity 26.4 years; US government bonds
- SPDR Bloomberg Barclays International Treasury Bond ETF (NYSE:BWX); priced in US dollars; average maturity 9.7 years; 54% Europe, 23% Japan, 23% rest of world (mainly Australia, Canada, South Korea and Mexico)
- iShares Euro Government Bond 7-10 Year UCITS ETF (London:IBGM); priced in euros; average maturity 8.4 years; government bonds in the eurozone (France, Italy, Germany, Spain, etc.)
- SPDR Barclays 15+ Year Gilts UCITS ETF (London:GLTL); priced in British pounds; average maturity 29 years; British government bonds
Clearly these funds are in different currencies. IBGM and GLTL would look worse if shown in US dollar terms, as that currency has strengthened during the year. Also the prices of bonds with longer maturities are more sensitive to yield changes than shorter maturities. Hence the biggest price moves are in TLT and GLTL.
Still, the pattern is clear. Bond yields fell and prices rose for much of the year. But in recent weeks and months there has been a sharp reversal of fortunes. For example, investors in TLT (long dated US treasuries) have lost 17% in five months. So much for “risk free”.
The question is, what happens next?
Has the bond bubble finally burst? Will it keep on bursting? Or is this merely a pause in the multi-decade trend? Could bond yields fall sharply again? Will we see even more ultra low or negative bond yields in the near future? If yields keep rising, what does it mean for stock markets?
Right now, bond yields remain pathetic. Ten year yields are 2.4% in the US, 1.4% in the UK, 0.38% in Germany, 0.04% in Japan and -0.13% (yes, minus) in Switzerland.
At those sorts of levels you need falling inflation, or major and prolonged deflation, to make a decent return. Even in the US – which looks the best of the bunch – the yield is still anaemic.
In the long run since 1900, US bond investors have made 2% real (above inflation) return in the US. If we assume inflation will be (just) 2% over the next decade then you’d want to see 10 year yields around 4% before getting interested. That’s still a long way away.
Of course if yields keep rising then bond investors will keep losing money as prices fall. But there could also be a knock-on effect in the stock markets.
Equity investors expect a higher return than bonds offer, to make up for the extra risk involved. As bond yields rise, so does how much investors in stocks want to make in future. To achieve that, market multiples like the P/E have to fall. (Not to mention that higher borrowing costs could hit the bottom line of leveraged companies, creating a double whammy.)
On the other hand there hasn’t been a decent crash in developed country stocks since the 2007-2009 global financial crisis. Any economic “recovery”, real or supposed, is also long in the tooth. So if we’re about to head back into recessionary times then yields could suddenly reverse, and bond prices would rise.
This is the view of famously bearish investment strategist Albert Edwards, at French bank Societe Generale. He recently wrote, about US treasuries: “…in the next recession I still expect 10 year yields to ultimately fall to minus 1%…”.
Is he right? Maybe. But for now the market momentum is heading the other way.
For now I still reckon investors should steer clear of bonds. Instead they should have relatively large allocations of cash “ammo”, especially US dollars. (See “Where should you put your money?” from September for my full recommendation on asset allocations, including the avoidance of bonds.)
It’s not yet time to dip a toe in the bond markets. But if 10 year yields get to somewhere around the 3.5% to 4% range then I’d be tempted to make a small allocation. For now though, I’m still steering clear.
Stay tuned OfWealthers,