The US shutdown is over (markets barely noticed one way or the other). The US stockmarket continues to hit new highs at a rate of knots.
All is well and all shall be well in the world of investment, it seems.
Yet there’s one wisp of cloud in the otherwise blue sky. The bond bull market that has supported ever-rising equities for many years now is at an end.
So the question is: how high can bond yields go before the equity market starts to get jittery?
The bond bull market is over – how bad will the bear get?
The yield on ten-year US Treasuries (what it costs the US government to borrow money for ten years) yesterday hit a three-and-a-half-year high of just over 2.66%. It’s ticked a bit lower this morning, but it’s still hovering around the 2.6% mark seen by many analysts as a significant level.
By way of background – bond yields fall as bond prices rise, and vice versa. And give or take, bond yields have been falling globally since the early 1980s. In other words, the cost of borrowing has been falling pretty much across the board for more than three decades.
Any turnaround would represent an epochal shift into a type of investment backdrop – one of rising (or even flat) nominal borrowing costs – that very few currently active investors have been alive for long enough to experience.
So can we be sure that the bond bull market is actually over?
Well, there are plenty of good reasons to expect bond yields to rise this year. Firstly, global growth is strong. When economic growth is strong, that tends to be inflationary and leads to interest rate rises. That’s bad news for bond prices.
Secondly, the US government (and other global governments) is going to be issuing a lot of debt this year. So bond supply is going to go up. As Chris Flood pointed out in the FT yesterday, this year, “the supply of US Treasury bonds is set to almost double” – to an incredible $1trn.
And it’s not just the US government. “The amount of investment grade and high-yield bonds issued by US companies that will mature and require refinancing is forecast to increase significantly over the next two years.” So there’s going to be a lot of debt out there competing for buyers.
Thirdly, on that demand side, the US Federal Reserve is no longer actively stepping in as the buyer of last (and first) resort. Quantitative easing has meant that the bond market has had a price-insensitive buyer sitting in the market for many years now. That’s changed.
And again, it’s not just the US. The European Central Bank and the Bank of Japan are both expected to wind down their own bond-buying schemes. That means another big source of demand – some of it trickling out into international markets – will be leaving the market too.
So in all, we have higher supply, falling demand, and a macroeconomic background that’s ultimately rather hostile for bonds. That really doesn’t sound good. Indeed, as we’ve mentioned previously, “bond king” Bill Gross argues that the 1.45% yield seen on ten-year Treasuries in July 2016 “can legitimately be cited as the end of the bond bull market which began at 15.8% in 1981”.
The bond market number to look out for
So what does that mean?
Gross himself is predicting only “a mild bear market”. He reckons the US ten-year yield will reach around 2.7% by the end of the year, which is not exactly Armageddon levels.
But how high do yields have to go to start affecting wider markets?
As John Authers notes, a number of analysts reckon the level is currently around 3%. Absolute Strategy Research points out that this is when bond yields will exceed the cyclically adjusted earnings yield on stocks (this is simply the inverse of the price/earnings ratio – so it effectively presents the p/e ratio as an interest rate).
In essence, it’s the point at which the return on bonds eclipses the expected return on equities, which would attract money into bonds rather than stocks.
Similarly, Michael Hartnett of Bank of America Merrill Lynch reckons that Treasury yields above 3%, combined with wage inflation at a similar level and the S&P rising above 3,000, will be the trigger for a correction.
On the one hand, 3% is not very far away from here. On the other hand, you could have said that three and a half years ago, and you’d still have been waiting.
The main thing is to keep an alert eye on what’s going on in the bond market. It’s already clear that sectors which will struggle with higher interest rates – such as commercial real estate, for example – are underperforming the rest of the market.
And I can’t help but think that the wobbles at the high end of global residential property markets are due to signs that tighter money is on the way.
You could even ponder whether bitcoin’s recent wobbles are partly due to the threat of higher rates – cryptocurrencies strike me as the ultimate manifestation of our QE, zero-interest rate world. With that world on its way out, can bitcoin and its cousins continue to thrive?
Anyway – keep a close eye on bond yields, and have some exposure to sectors that will benefit more from an inflationary backdrop – mining and energy are two obvious ones.