WILL US BOND YIELDS EVER BE NORMAL AGAIN?

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1 WILL US BOND YIELDS EVER BE NORMAL AGAIN? Adrian Hilton Head of Global Rates and Currency Investments, Fixed Income nglobal demand has recovered strongly since the global financial crisis, but yields remain far from normal levels na partial reversal of globalisation that has delivered a disinflationary environment since the 1980s could see past highs regained n It s a critical time for bonds as the era of unconventional monetary policy appears to be drawing to a close On 30 September 1981, Ronald Reagan was eight months into his presidency. The US unemployment rate was above 7%. 1 MTV had just aired for the first time on cable TV. And Nintendo had recently launched an arcade game, Donkey Kong, featuring a peripheral character called Mario who was, it turned out, destined for great things. More relevantly, 30 September 1981 marked the all-time peak in 10-year US Treasury yields at nearly 16%. Since that day the bond market has been in what looks like when viewed from a wide enough angle an irresistible bull market, with yields declining almost every year until finding a bottom in the summer of 2016 at around 1.35%. 2 This was almost a decade after the trauma of the global financial crisis (GFC), when deflation was only narrowly avoided in the US. The orthodox monetary policy rulebook was ripped up and the world was flooded with liquidity. Borrowing costs were slashed, central bank balance sheets ballooned and government bond yields were driven to extraordinarily low levels. In many parts of the world, the low in bond yields was lower still: the shorter-dated part of the German yield curve still trades at yields below zero. Ten years on from the Lehman Brothers crisis, unemployment is below 4%, quarterly annualised growth printing over 3%, business confidence at record levels and wage inflation recovering. The Federal Reserve has ended its quantitative easing programme, hiked rates by 200bps and already begun to normalise the size of its enlarged balance sheet. Global demand has recovered strongly and the US is enjoying a sizeable fiscal stimulus package, delivering tax cuts for individuals, investment incentives for business and an increase in government spending. 1 Trading Economics, Macrotrends, 2018.

2 But while yields have managed to rise a bit from the lows before the presidential election, why are they still so far from the normal levels we used to know before the crisis? To answer, it s useful to decompose the bond yield. Broadly, the yield on a safe asset like a government bond ought to reflect expected inflation, the expected future path of interest rates and the term premium, which we can think of as the extra return required by investors for holding a longdated bond over and above the compensation they receive for the evolution of interest rates over that period. Taken together, expectations of future inflation and short rates might be termed as the risk-neutral rate. It s been in decline for an extended period, not least because inflation itself has trended lower. Globalisation in all its forms has been largely to blame: free trade, the integration into global markets of low-cost products, the lubrication of supply chains, ecommerce and deregulation have all reduced the outlook for prices. Additionally, the erosion of workers bargaining powers since the 1970s and the promotion of independent central banks from the 1990s have been influences. Similarly, some commentators believe that the severe post-gfc recession (especially in Europe) has smothered inflationary pressures for a generation. The long-term deterioration in expectations of future policy rates may be related to a structural decline in the combination of factors that define the economy s equilibrium real rate. That s the inflation-adjusted rate that an economy requires to the equilibrium of trend growth and stable inflation. Central banks set their own policy to nudge market rates towards the neutral rate and thus create the conditions for sustainable growth. GLOBAL SHIFTS AND DEMOGRAPHICS Much has been written on the structural decline in equilibrium real rates and its drivers. Analysis conducted by the Bank of England suggests that the bulk may be accounted for by a shift in global ex-ante savings and investment preferences. 3 In other words, the world s desire to save has increased over the past 40 years, relative to its desire to invest, increasing demand for safe assets such as government bonds and depressing their yields. Demographics are likely to have played a big part: as the baby boomer generation has matured and the birth rate slowed, the dependency ratio the proportion of the population not of working age has fallen, increasing the global desire to save. Rising inequality, particularly in advanced economies, may also be to blame since incomes have become increasingly skewed towards those with a higher propensity to save. Meanwhile, emerging market governments, especially in Asia, have sought to increase their foreign currency savings as a defence against capital outflows. 3 Lukasz Rachel & Thomas Smith, Secular Drivers of the Global Real Interest Rate, Bank of England Working Paper No. 571.

3 On the other side of the coin, investment preferences have been subdued in part by the declining cost of capital goods relative to consumption goods, ensuring that just maintaining constant investment volumes requires a smaller share of GDP. The result is that the real interest rate required to balance the global economy s desires to save and invest is now much lower than it was in Besides shifting saving and investment preferences, a lot of the decline in real rates can be accounted for by slowing rates of economic growth. An examination of US data (such as that conducted by Robert Gordon 4 ) suggests there has been a two-phase structural decline in US economic growth during the past 50 years. Between 1970 and 2006, slower productivity growth was partially offset by higher hours worked, but from 2006 to the present even slower productivity has been exacerbated by a significant decrease in hours worked. Demographic effects probably explain the recent failure to match the hours worked by earlier cohorts: population growth peaked decades ago thanks to declining fertility rates after the baby boom; and labour force participation, driven between 1970 and 1990 by higher female engagement, has been drifting lower since. A bigger puzzle than the slowing growth in hours worked, perhaps, is that the growth in output created in each of those hours has slowed. Productivity growth is volatile and hard to measure in real time, but the downward trend in recent years is clear. From post-war rates of around 3% per annum the US harvested the fruits of the electricity revolution, and apart from a period of decent improvement during the 1990s computer revolution, productivity growth has been in secular decline. Since the dotcom bust it has grown at a mere crawl. The reasons are many and much-debated. But it is likely that at least part of the explanation lies in the structural changes undergone by industrial economies as they become more oriented towards services. The big advances arising from 20th century urbanisation, electrification and improved communication may have already been exploited; it may now simply require far more resources to develop ideas with meaningful economic impact than in an earlier age, reducing the rate at which a mature economy is capable of improving efficiency. REGAINING THE HIGH GROUND How then might US bond yields regain the high ground, if not of 1981 then of 2001? One way might be a partial reversal of the globalisation effects that have delivered such a disinflationary environment since the 1980s. Unthinkable only a few years ago, the rise of populist politics, often with a nationalist or anti-globalist flavour, presents exactly such a threat to the modern free-trade orthodoxy. A reversal in the broadening of the world labour pool and the integration of low-cost producers into the global economy could worsen the benign trade-off between growth and inflation that policy makers have enjoyed for so long. 4 Gordon, Robert J, Why Has Economic Growth Slowed When Innovation Appears To Be Accelerating?, CEPR Discussion Papers

4 Secondly, estimates of the productive potential of the US economy might be upgraded, forcing upward revisions to the assumed equilibrium real rate and the future path of central bank policy rates. It is possible that the outlook for productivity growth is underestimated, either because the gains from recent technological innovation are mis-measured or because the lag between that innovation and its economic traction are simply longer than we think. The third way in which higher bond yields might be achieved is via an increase in the term premium, that mysterious wedge of the bond yield over and above (or under and below, as at present) the compensation required by a holder to compensate for the future path of short rates. That could rise as a result of an increased risk of nasty inflation surprises, such as those seen in the 1970s and 1980s, or a turnaround in the high demand for safe assets observed in recent years from central bank QE programmes, risk-averse (and regulation-constrained) financial sector actors and overseas investors engaged in recycling current account balances into US assets. It s a critical time for the bond market: US growth and policy rates are beginning to normalise and the era of unconventional monetary policy appears to be drawing to a close. Given what we know or think we know about the macroeconomic environment, valuations seem broadly appropriate. But for yields to break meaningfully on to the sunlit uplands of earlier decades, some long-term structural trends need to shift firmly into reverse.

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