The equity markets have started off 2018 on the front foot. Gains have been broad based with all the major asset classes advancing. Only government bonds have struggled to gain traction. So far in 2018 the S&P is up +4.2% while small-cap equities are up +3.6%. International equities are doing well with the developed EAFE up +4.5% and emerging equities up +5.1%. As we talk about in our quarterly letter that will be published soon, optimism about synchronized global growth and the earnings repercussions are driving the markets. As you can see below, the rally in 2017 largely reflected a better earnings backdrop (blue line is earnings, yellow line is the S&P total return).
The one area of weakness has been in the bond market. The yield on the 10-year has advanced from 2.40% on 12/31/17 to 2.55% on Friday. This means intermediate-term government bonds have lost -1.0% this year while long-term bonds are down -1.8%. We have added German 10-year bond yields to the table above to track possible rate normalization in the eurozone this year (more on this below).
Finally, perceived inflation hedges have rallied. Broad based commodities are up +1.2% this year while gold and silver are up +2.7% and +1.8% respectively. Crude oil has also continued the rally that started last year.
What to Make of the Bond Market?
As we noted earlier, bond yields have pushed higher this year, as you can see below.
There are a few factors at play
Let’s start with something that almost certainly won’t weigh on bond prices for any length of time. This week there was a news item suggesting that China will slow or stop its purchases of U.S. Treasury debt (China’s State Administration of Foreign Exchange (SAFE) decried the report as ‘fake news’). Lost in the commotion was the fact that China’s holdings of Treasuries have been largely flat as you can see below.
When it comes to China we should not forget that China still actively manages their currency versus the dollar. Now that capital is no longer fleeing the country China must take steps to stop too rapid appreciation of the yuan. To do this they are forced to sell yuan and buy dollars. This means basically buying Treasury bonds. It is hard to see China abandoning Treasuries unless they are willing to suffer massive currency movements that will hammer their own economy.
More fundamentally, bond yields have ticked higher for a more prosaic reason – inflation. Granted, you might have to squint to see it in the chart below, but inflation expectations have ticked up the last few weeks. The market is now thinking inflation five years from now will average roughly 2%, up from 1.8% a couple months ago. This isn’t a big increase (coming out of the financial crisis inflation expectations were as high as 3%), but with bond yields as low as they are any increase is meaningful.
The rise in expectations appears to be backed up by December’s Consumer Price Inflation (CPI) report. This showed that the core CPI price index increased by a more-than-expected 0.28%, and the year-over-year rate rose to +1.8. This increase was the fastest in nearly a year, as you can see below.
Inflation isn’t soaring, but simply moving towards the Fed’s target of 2%. After a number of years where inflation has underwhelmed, we may see a year where inflation perks up a little.
But we shouldn’t get carried away. The chart below plots private credit growth (blue line) against core inflation (red dotted line). Credit growth is averaging 4%, not a number consistent with a huge spike in core inflation. Maybe credit growth accelerates and core inflation moves towards 2%, but we are not talking hyperinflation.
What does this mean for Fed policy? It simply increases the odds that the Fed raises rates three times, rather than two. They have been telling us for some time now they see three hikes in 2018, but the market in general has struggled to believe them, pricing in only two hikes up until recently. However, rising inflation expectations at the same time the economy is running at full employment means that a hike every four months seems about right, with the first one in March. The As Goldman Sachs noted on Friday:
“If core PCE prices rise by the amount implied by the December CPI and PPI data, core inflation will have risen three tenths from the August lows. Reflecting this and the strong holiday season, we increased our Fed probabilities, with subjective odds of a March hike at 85% (from 75% previously).”
The recent increase in rates is the market’s way of pricing in a more aggressive Fed.
Tighter Global Liquidity Conditions
Both the European Central Bank (ECB) and the Bank of Japan (BoJ) made noises about cutting back their stimulative measures this week. More significant of the two were the minutes from the ECB’s December meeting. They talked about revisiting their communication stance in early 2018. This was taken as a sign that the ECB will renormalize monetary policy more quickly than the market is discounting. Currently the ECB’s bond buying plan runs through September of this year and some think this may wind down quicker than previously thought.
This is unlikely unless inflation really pops higher in the eurozone, but it does highlight a big issue with the outlook for this year. Global central banks are on track to significantly cut back the amount of liquidity they are pumping into the system. As you can see below, the amount of money central banks are funneling into local bond markets is likely to fall from roughly $2.4 trillion year-over-year to $400bn by the end of this year.
By 2019 they will be draining liquidity. This of course assumes the ECB continues their bond buying through September and the BoJ changes nothing over the next few quarters.
Any way you look at it this is a big experiment. The last time bond purchases went negative was in 2013 and we saw a modest increase in bond yields in the U.S. (intermediate-term Treasuries were down over 6%). Could we see something similar this time around?
Certainly U.S. bond yields could back up further. May the 10-year with a 3 handle on it at some point? But in our mind the biggest risk in the bond market is in Europe. For example, the German 10-year Bund yields just 0.58% compared to 2.56% in the U.S. However, European growth could actually surpass that of the U.S. this year. There is much more room for European yields to increase. They could double and still be considered low by historic standards.
All of this analysis is shorter-term, say the next twelve-to-eighteen months. Looking beyond that there is a chance that tighter financial conditions could cause a recession. After all, in the post crisis world we may have grown reliant on cheap money. If it goes away the global economy may falter. If this was to happen bond yields could revisit the lows as deflation comes back with a vengeance.
But What About Debt?
A common argument for higher bond yields here in the States is that our burgeoning government debt levels will inevitably lead to higher long-term rates. This is especially so after the latest tax bill. As you can see below, government debt to GDP is projected to push towards 100% over the next few years (red dotted line).
However, empirical evidence refutes the notion that the higher the debt ratio, the higher rates go. The chart below plots 10-year bond yields against total debt to GDP. There is a clear negative relationship.
Japan is a great example. Periodically over the last twenty years traders conclude that the country is headed for fiscal ruin because of its ever-rising debt levels which would inevitably collapse the bond market and the yen. There is even a name for the trade of shorting both the yen and Japanese bonds – the widow maker. Those who made the trade over the years lost their shirts as Japanese bond yields proceeded to fall to 0% and the yen rallied.
Debt crisis accompanied by soaring bond yields happen when countries issue a lot of debt in a currency they can’t print. Think of Mexico. They issued a lot of dollar denominated debt in the 1970’s and 1980’s they couldn’t pay back when their currency weakened. Same with Argentina a few years ago. Japan and the U.S. all issue debt denominated in their local currency. That makes a huge difference.
We suspect the growth, inflation, and liquidity dynamics support modestly higher long-term rates over the next few months. But we have seen this movie before. Over the last few years numerous calls have been made for higher rates. In some years, such as 2013, this has panned out. In most years, it hasn’t. A Wealth of Common Sense had a great summary of past calls for a bond bear market that I reposted below:
If anything, this a cautionary tale against making any big allocation moves based just on what is above the fold in the papers or even recent market moves. Yes, rates could move higher from here (we have positioned our allocations for this), but we doubt we see a huge surge in yields in the U.S. The risks are bigger in Europe, though.
Bottom line: At the margin position for higher yields, but bonds will continue to play a critical role in most portfolios as a key diversifier.
Have a good weekend.
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