One of the more remarkable features of global financial markets in 2017 so far has been the failure of long-term bond yields to rise all that much, even though global growth and equity markets have improved. This appears to largely reflect market confidence that central banks will retain extraordinary monetary stimulus, even in the face of what are now near full-employment conditions in their respective economies. This seems unsustainable, and risks to bond yields appear to the upside.
Bond yields fail to rise despite improved risk sentiment
As seen in the chart below, after a strong rise over the second half of 2016 – reflecting prospects for US fiscal stimulus and renewed Fed tightening expectations – long-term bond yields across major developed economies have generally eased back in 2017 so far.
This can’t be attributed to an upsurge in “risk-off” sentiment, however, as global equity markets have continued to make good gains. Indeed, US employment growth has also remained robust and the US Federal Reserve has remained resolute in its intention to raise official interest rates this year. Political risks in Europe have also eased, with voters consistently rejecting the temptation to vote into power anti-EU populist political parties.
Bond market: complacency amid stretched valuations
Despite further gains in short-term interest rates in the US and still relatively stable long-run inflation expectations, US 10-year bond yields remain trapped in their recent 2.3 to 2.6% range.
As we have previously explained, one explanation for low long-term bond yields is a very low “term premium” demanded by investors for taking on the price-volatility risk of holding long-dated fixed-rate securities. As seen in the chart below – taken from the Reserve Bank’s latest quarterly Statement on Monetary Policy (SMP) – the US 10-year bond term premium, while up on its lows of mid-2016, is still effectively only around zero, and well below historic norms.
Despite the very low risk-premium embedded into US long-term bond prices, investor attitudes remain quite relaxed. Indeed, as seen in the chart below, implied US bond market volatility – taken from the pricing of bond options – also remains well below long-run average levels.
Central banks appear to blame
Why are bond investors so complacent? The fault, it seems, remains that of global central banks. As noted by the RBA in its recent SMP, “Japanese and euro area residents made sizeable purchases of US Treasuries over 2016 in response to the influence of BoJ and ECB purchases in their respective domestic sovereign bond markets.”
In other words, the bond buying programs of these central banks forced hapless Japanese and European investors to chase yield in the US market, which in turn also helped drive down US yields. To an extent, the same forces operated in Australia, which also contributed to the strength in the $A.
That said, the RBA notes that since late 2016 “Japanese residents have been net sellers of US Treasuries and net purchases by euro area residents have slowed substantially.” But while that may be so – and perhaps contributed to the late-2016 rise in US yields – it remains the case that US bond yields have remained remarkably well contained in 2017 – suggesting demand for long-dated Treasuries has generally remained firm.
Indeed, in December last year, the ECB announced it would extend its bond buying program (due to have ended in March) until December 2017, though monthly purchases from April would be reduced from €80 billion to €60 billion. In Japan, the BOJ is still buying whatever it takes to maintain its zero yield target on 10-year government bonds. Only the US Federal Reserve has recently started to hint it could begin reducing its huge Treasury holdings later this year.
What’s remarkable is that this policy timidity comes at a time when unemployment rates in both the US, Japan and (parts of) Europe have fallen to below pre-financial crisis levels. According to the RBA, “the United States, Japan and some euro area countries are now around estimates of full employment.”
As for concerns about inflation, it also remains the case that core or “underlying” rates of consumer price inflation are now not far from levels that prevailed in all three economies prior to the financial crisis.
In short, the case for continued extreme monetary stimulus appears to have well and truly passed. Far from worrying about unusually low inflation or weak economic growth (neither of which currently exist), G3 central banks should instead be increasingly concerned about the potential financial instability risks – such as inflated equity and corporate bond valuations – posed by their persistent distortion of bond market pricing.
When and if global bond yields start to re-normalise, one investment exposure that seems likely to perform relatively well is global banks – for reasons we outlined here. Investors wishing to gain exposure to global banking stocks can do so through the BetaShares Global Banks ETF – Currency Hedged (ASX Code: BNKS).