In a ING new report entitled ‘The Warped World of Bonds’, I argue that the idea that we might be settling into a ‘new normal’ is fanciful. With the financial crisis still mutating, the valuation basis of the bond markets is likely to remain in a state of flux.
The traditional mental model of bond investors has been to think of bond yields as being largely driven by a risk-free real yield and inflation expectations, leaving only a relatively small role for term (or risk) premia. Thus, prior to the financial crisis, consensus expectations for 10 year government bond yields tended to be anchored around expectations for nominal GDP growth, typically at close to 5% in the US, and around 4-4 ½% in the Eurozone.
Since the onset of the financial crisis, bond yields have increasingly diverged from these growth and inflation fundamentals. Yields in the US, UK and Germany have fallen to record lows, well below levels that might have been expected given their previous growth and inflation performances. At least in theUS and theUK, these yield declines have also occurred despite an explosion in public sector deficits. US 10 year yields are now perhaps some 200bp below where traditional fundamentals might suggest that they should be.
So what explains this divergence?
1. Default risk and the death of ‘risk free’ – the dramatic crisis-induced deterioration in public finances that occurred in 2008-9 and the subsequent emergence of the Eurozone’s sovereign debt crisis has confronted investors with the reality that government bonds are not ‘risk free’. This is a radical threat to the foundations of portfolio theory.
2. Unconventional monetary policy – with growth struggling in the face of fiscal austerity, and official interest rates already at rock-bottom, the central banks have been forced to step in with massive bond purchases and liquidity infusions.
3. Financial repression – with their solvency under threat, governments have been keen to encourage banks and other financial institutions to keep buying their debt. New regulations such as Basel III and Solvency II have incentivised them to do so.
4. Flight to safety in a Risk-on, Risk-off world – the flight from the Eurozone’s peripheral bond markets has given a huge downward push to yields elsewhere.
With economic growth struggling in the face of sustained fiscal austerity the central banks, backed in the Eurozone by the ESM, may have to step up their efforts to keep yields low. The world of government bonds looks likely to remain warped for a great deal longer.
What ‘New Normal’? Welcome to Warped World
- The financial crisis continues to mutate
- The ‘risk free’ rate is dead
- Political uncertainty exceeds economic uncertainty
- Economic models don’t work well in a world of structural change
- Central banks will continue to improvise and intervene
- The regulatory rules continue change while the game is being play