We ask industry figures if bond yields could fall even further from these historic lows?
Stewart Cowley, head of fixed income, Old Mutual Asset Managers
There is a strong case for keeping the cost of borrowing down for corporations, especially when we are facing limited pricing power for companies and low growth in the Western world.
To achieve low borrowing costs, benchmark government bond yields have to be kept low.
Although there is some uncertainty about exactly how so-called quantitative easing actually works, what it clear is that you have to do a lot of it to have even a limited effect.
So whilst banks are unwilling or unable to lend on a large scale, I am indifferent as to exactly how we get to the result; either by natural forces or market manipulation there is a case for sending government bond yields to all-time lows.
In that case, Western yields will converge towards those seen in Japan, but investors should not confuse the similarity of results with a similarity of circumstances. One day we will emerge from this situation and the normalisation of interest rates and bond yields upwards will cause a brutal and disruptive shock to bond funds unable to cope with a rising yield environment. Declining bond prices will lead to tangible capital losses.
Thomas Becket, chief investment officer, PSigma Investment Management Limited
I think the lesson investors should adhere to at the moment is 'never say never'. The recent collapse in bond yields is telling you three things - growth will be lower in future, inflation will not be a problem in the short term and brief bouts of fear will be the order of the day. I agree tentatively with all of these points, although am less convinced by the inflation argument than the other two. However, despite the Central Bankers increasingly aggressive aim to flatten the yield curve, which could lead to bond yields falling yet further in the short term, I fail to believe that the miserly yields on offer from government bonds make them a sustainably attractive medium to long term investment.
Presently, we see no value at all in conventional government bonds (and by implication high grade corporate credit), which would benefit from persistent deflationary fears. This is a completely different scenario to the last time that deflation was an issue for markets in 2008, when we loaded up on government bonds and built up cash positions, as we knew that the path of interest rates was downwards and the yields were still attractive. In fact, we now think you might suffer serious losses, should interest rate rises and inflation start to become a feature for markets in the quarters and years ahead. Having been fooled by misplaced thoughts of a Panglossian 'Great Moderation' last decade, there is a real chance that this decade might see the 'Great Inflation', which would be an extremely negative environment for fixed interest investments.
Ross Watson, portfolio manager, Securities Trust of Scotland
Earlier this year, it became clear the Bank of England’s experiment in quantitative easing was nearing its end. As the central bank had been the only buyer in town, there was much speculation that bond yields had been depressed by its purchase of some £200bn worth of gilts directly from investors, and yields would rise once the easing was withdrawn.
Indeed, the Bank’s own study suggested yields would probably increase by 70–80 basis points. So far, so plausible – except gilt yields have fallen by that amount, taking ten-year maturities to under 3%.
Buyers at this level are presumably happy with both the level of return and the level of risk; remember that just a few months ago the size of the public-sector deficit was calling the UK’s prized ‘AAA’ rating into question.
But could yields fall further still? They could if more people become convinced deflation remains a serious possibility.
But this would be to ignore the Bank of England’s 2% inflation target and the fact its governor has just written to the Chancellor of the Exchequer to explain why inflation is more than a percentage point above the target again. Inflation has been stubbornly high for some time, and the impact of higher food prices will soon be felt.
If the 2% inflation target has any credibility for the medium term (and I believe that it does), then accepting a 3% return for a ten-year gilt and less than 2% for a five-year maturity offers a real return far below that required in the past.
For the taxpayer, it is excellent news that the Government can fund its deficit at such low rates. But anyone contributing to a pension scheme must have very mixed feelings about accepting such low returns.
Craig Inches, government bond fund manager at Royal London Asset Management
In recent weeks bond yields have been driven lower as US economic news has deteriorated. News from Europe including the UK has actually been reasonably upbeat, with the UK posting a very strong GDP figure in the second quarter and Germany posting an even stronger one. However, bond markets take their cue from the US Fed and on the back of weaker data, the Fed’s view of the world has turned less positive.
Therefore it is extremely possible the US could embark on QE2! This further stimulus would result in lower bond yields and would likely drag the UK with it.
Regardless of this threat, we currently see no value in shorter than 5 year gilts. The yield on these assets must become negative over the medium term to outperform the returns currently available on corresponding cash instruments. Equally with ten year yields in the UK at 2.9% and RPI currently running at 4.8%, the medium term real return outlook for conventional gilts looks extremely poor.
It actually points investors in the direction of positive yielding index linked gilts which, although at equally low yield levels, look a much better investment.
And last but not least, the most attractive asset on the gilt curve right now is long dated conventional gilts.
It may be difficult for long yields to continue to push lower without further deterioration of the economic picture, but what is certain is that in either a double dip or recovery scenario these assets will outperform all other gilts on a risk adjusted basis.
Rod Davidson, head of fixed income, Alliance Trust Asset Management
Yes is the simple answer, especially as we have not yet reached the historic lows of both the US and Japanese bond markets. Economic and financial market uncertainty, talk of further monetary stimulus to offset fiscal contraction, and little prospect of central banks moving the key rates higher over the next twelve months all point to the distinct possibility government bond yields could fall further into the year end.
Bond yields began trending lower in April this year but it was not until employment growth in the US failed to materialise and the housing market stalled that the rally in bond markets really began to take hold. In the absence of any positive economic news US 10 year yields are expected to test their historic lows at around 2.20% and this move is likely to take UK and German yields lower in unison. However, although extensions to existing QE programmes are possible, at the moment they are far from being a certainty and this suggests there is scope for disappointment in government bonds.
Even taking into account the precedent set by the Japanese bond market over the last twenty years bond investors cannot ignore the threat inflation poses when the developed world exits this current round of gloom. The investment team at Alliance Trust does not believe the UK will drop back into recession and, with inflation forecast to remain above the Bank of England’s upper band for the foreseeable future, it would be prudent to start building protection into your bond exposure should the turn in the interest rate cycle happen ahead of current expectations.
Mike Story, Legg Mason affiliate Western Asset – product specialist
Low bond yields do not necessarily imply accommodative monetary policy. A low nominal yield may also be a sign of expected deflation and overly restrictive monetary policy. Because nominal yields cannot go below zero, real yields are driven higher to the extent that expectations turn deflationary. Japan’s GDP deflator (a price measure across the entire economy) has averaged -1% per year since 1995, leaving the 10-year nominal yield below 1% and real yields at restrictive levels. Japan is in a deflation trap. The possibility that the US and parts of Europe become ensnared in a Japan-style deflation trap is no longer negligible.
The early monetarists rejected the possibility of deflation traps. If inflation is defined as an excess supply of money, then deflation is defined as an excess demand for money. It follows that the solution is simple: print money until supply exceeds demand. Clearly a central bank is able to prevent persistent deflation. But is it willing? Ben Bernanke attributed Japan’s deflation trap to “self-induced policy paralysis”. A central bank cannot raise inflation expectations – and lower real yields – unless it can convince markets that it is willing to break type and take permanent, audacious action, including raising its long-defended inflation target.
Divisions have surfaced within policy-setting committees, suggesting that, while not yet suffering from “self-induced policy paralysis”, the decisiveness with which they reacted in late 2008 is fading along with the acute threat of economic catastrophe. A gradualist approach to monetary policy is the perfect ingredient for a deflation trap and far lower yields.
Simon Callow, assistant manager of the Midas Income and Growth Trust
In any asset bubble, investor confidence is reinforced by simple price appreciation. This process becomes self-fulfilling, as more buyers enter the asset class leading to further price appreciation.
George Soros’s “reflexivity” concept applies to the fundamentals of today’s bond market. Sentiment is helped by the media headlines justifying the prevailing momentum producing a virtuous circle. Caveat emptor! Over the last 15 years, emerging markets, technology stocks, property, oil and now bonds have all found themselves victims of this process.
I digress and back to the question in hand to which the answer is of course, yes. As in any bubble, bond yields can continue to fall further and reach new lows, but that does not make them a buy. The thought of investing in the UK treasury 10 year benchmark gilt at double digits above par, thereby guaranteeing a capital loss to redemption on 7th March 2020 simply does not seem the most prudent way to invest capital. The corrosive effects of inflation also need to be considered, not exactly being insignificant, trending at 3%.
Of course advocates of current bond yields cite the threat of deflation and the prospect of a double dip recession as justification for investing in bonds and lower bond yields. However, the new joker in the pack of cards is the manifest change in the UK government’s attitude to debt and capital allocation. As crowding out dissipates, and private sector job creation takes hold, the future fortunes of the risk free asset might not look so risk free.
Chris Higham, fund manager of the Aviva Corporate Bond and Aviva Strategic Bond
Yes – for a number of reasons.
Firstly, it is said ‘we are living in uncertain times’ and history has shown that with uncertainty, demand for ‘safe haven’ assets increases. With recent macro economic data suggesting global growth is slowing, investors have altered the composition of their portfolios with higher weightings toward cash and cash equivalents – including government bonds. Should future economic data confirm stalling or even a reversal of global growth, bond yields could fall further.
Secondly, inflation expectations influence prevailing bond yields and there is division within the investment community regarding the future path of inflation. A quorum of investors suggests that developed economies may be entering a prolonged period of ‘deflation’ as the excesses of the ‘great moderation’ are unwound. Should this eventuate, bond yields could fall further.
Lastly, we have seen unprecedented intervention by central banks with ‘quantitative easing’ being used to support falling asset prices as official policy rates edged toward zero. Markets are waiting for evidence that monetary authorities are prepared to engage in ‘QE2’, which will likely result in the purchase of government securities – as evidenced by the recent reinvestment of the Federal Reserve’s balance sheet into US Treasury securities. Should ‘QE2’ become a reality, bond yields could again fall.
Any, or a combination of these possibilities means that bond yields can reach new historic lows. Of course, they can also move quickly in the opposite direction – perhaps due to inflation fears or because investor appetite for riskier assets increases. Only time will tell.
Oliver Stones, head of fixed income, Quilter
Yes they can, but the more pertinent question is whether these low yields can be sustained in the long term? We do not believe they can.
It is still unclear whether we are heading towards a period of deflation similar to that which Japan has been experiencing for over a decade. Yields on 10-year Japanese government bonds are currently 0.91% compared to US treasuries at 2.52%, German bunds at 2.18% and UK gilts at 2.87%. The emergence of deflation will determine whether we will join Japan with sub-1% bond yields or not. The deflation versus inflation debate is far from over and the balance of risks are far more finely balanced than our central bankers would have us believe, but we view inflation as being our long term threat, not deflation.
Importantly, what can be done to stop bond yields sustaining low levels?
First, investors will need to accept that peripheral European sovereign debt markets are not still on the brink of default.
Second, a clearer picture of the developed economies is needed. This will mean having evidence that they are not heading into a double-dip recession, but rather are following a continued path to recovery. Key indicators will be improved housing markets, enhanced consumer credit, inter-bank lending and borrowing, and falling unemployment rates in the face of severe government austerity programmes and fiscal book rebalancing.
Colin Harte, manager Baring Absolute Return Global Bond trust
They can, if investors remain pessimistic about the outlook for economic growth. However, developed markets are pricing in not just the risk of inflation but the risk of deflation too now, and if economic data are stronger than expected, investors should anticipate a sharp rise in bond yields.
We model the risks to the world economy using three scenarios that pass our probability threshold. The first involves a US-led recovery, and the second a return to anaemic growth, which acts as a catalyst for the Southern European economies to leave the Euro and a return to quantitative easing in the US. Our third scenario involves a credibility crisis, where investors become concerned that US, European and Japanese policy makers are prepared to inflate their way out of debt.
We would expect to see a substantial rise in bond yields under the first and third scenarios, with little upside from here under the second. In our view, the decision of the US authorities to reinvest the principal from maturing ABS credits into Treasuries risks was a policy error, as we believe the natural rate of employment has risen significantly and will eventually lead to higher inflation over time. In the same way, we believe the policy stance of the European Central Bank is much too accommodative for core Europe, where growth is surprising on the upside.
We have positioned the Baring Absolute Return Global Bond Trust with a negative duration to benefit from the likelihood of rising bond yields in this environment.
Simon Thorp, head of fixed income at Liontrust
The simple answer is yes. Investors and strategists consistently called the bottom of Japanese government bond yields throughout the 1990s only to be proved wrong as 10 year yields fell from 8% in 1990 to a low of 50bps in 2003.
Yields of sovereign debt in the safest G7 countries will fall further if economies double-dip and the threat of deflation becomes a reality. The recent fall in yields (10 year gilt yields have fallen over 100bps in the last four months) is partly anticipating this outcome.
Authorities have signaled that rates will remain on hold for the “foreseeable future”, which is a euphemism for however long it takes for the recovery to take hold. This is partly to ensure a “deflationary mentality” does not manifest itself with consumers.
If the Federal Reserve moves to enact further quantitative easing (QE), with a rumoured expansion of its balance sheet from $2 trillion to $5 trillion, over the next few months, yields can be expected to fall as this liquidity moves further out along the interest rate curve.
Markets are likely to be pulled between excessive pessimism and optimism over the next couple of years. There are enough positive macro economic factors (and inflationary trends) to make the threat of outright deflation unlikely, especially at a time when authorities will use all policy levers available to prevent it.
With yields already pricing in much of this pessimism, we feel the greater “tail risk” for markets over the medium term is higher yields as markets fret over the possibility of stronger than expected growth, the inflationary effects of QE and an imbalance between the demand for, and the supply of, liquidity.
April LaRusse, senior fixed income product specialist, Insight Investment
In making our forecasts for the gilt market, we first need to consider the outlook for the UK economy, and in this respect we do believe the UK economy will continue to grow, avoiding a double-dip. Given this view, this means the current stance of monetary policy is too loose. We are not talking about rates rising to a level where monetary policy is seen as tight per se, but just not remaining as low as we have today. However, the bond market is more fixated on the impact of government spending cuts and the potential for the double-dip scenario, and is not pricing in much in the way of either growth or rate hikes.
Certainly, while interest rates are not likely to change for the rest of the year, we believe the market will start to price in an interest rate rise next year, potentially for early 2011. Therefore we believe gilt yields are likely to be higher 12 months from now. However, in the short-term they may well continue to rally, benefiting from their safe haven status away from the turmoil in the eurozone. Therefore, in terms of duration and curve positioning, we are continuing to manage our portfolios on a tactical basis, taking advantage of opportunities as and when they present themselves.
Colleen Denzler, head of fixed income strategy, Janus Capital.
Uneven economic data and stubbornly high unemployment have suggested the US economic recovery is losing steam, fuelling the latest downtrend in rates. We think this could continue over the near term and that rates are more likely to remain near the low end of their recent range given the softening US economy, private-sector deleveraging and the disinflationary environment. Deflation is a greater short-term threat than inflation in our view, largely because of the excess capacity throughout the US economy and the deleveraging cycle currently underway.
We believe business spending will remain subdued given uncertainty over rising federal deficits, taxes and regulatory policies, which have prompted corporations to build up large cash balances versus hiring and investing. Meanwhile, consumer spending faces headwinds amid deleveraging, increased savings, high unemployment and a weakening housing market. Although we do not necessarily see negative GDP numbers, we feel more muted economic growth is a likely result.
We have longer term concerns over when the Federal Reserve will begin to unwind its large holdings of MBS and Treasuries and growing fiscal deficits. Rates could be volatile while the market sorts these issues out. For now, the US dollar and US treasuries are stilled viewed as safe havens, with strong demand for the latter suggesting the sovereign creditworthiness of the US is getting a passing grade. We think the best way to invest in the current environment is in corporate credit selection and Treasuries while avoiding Agencies and Agency MBS amid historically tight spreads and Treasury-like traits.
Guy Davis, investment manager, Charles Stanley
In a word, yes.
While yields are currently flirting with all time lows (the 10 year gilt yield has fallen to below 3%) there remains a real possibility that they could continue falling.
Firstly, the fact that the global economic recovery appears to be stuttering (particularly in the US and parts of Europe) has undoubtedly hastened the drop in yields. Investors have sought the safer haven offered by government (and to some extent, corporate) debt. On this front, a turnaround in the near future remains unlikely. The possible impending resumption of QE in the US (and possibly the UK) would also support prices by mopping up any excess supply in the market.
Another consideration is inflation expectations, or more precisely; the lack of expectations of inflation. While CPI inflation in the UK is currently running above target at 3%, the Bank of England maintains that this is a temporary spike, and investors seem to be buying into this view. Indeed, if we were to witness a period of deflation (due to problems such as deleveraging, spare capacity, and high unemployment) it is likely yields would continue to fall, as was the case in Japan.
Yet while yields may slip further from their current levels and may remain depressed for some time, it is important to remember they cannot stay low for ever. When the economic situation improves, yields will rise as risk appetite returns, and bond holders will be left nursing some uncomfortable capital losses.
Dr. Michael Hasenstab, Senior Vice President and Fund Manager of the Templeton Global Bond Fund
Weak labour markets and a lack of inflationary pressure in places like Japan, the Euro area, and the US are likely to mean that monetary policy stays loose over a potentially prolonged period. 2010 has witnessed markets coming to terms with the moderate nature of many developed economies’ recoveries from the global financial crisis as they have continued to push back the start of interest rate hikes and in some cases even seem to price in additional quantitative easing. Despite the sluggish recoveries that we forecast for these deleveraging economies, we see very little value in duration exposure in developed economies.
It is possible that a rise in risk aversion could push these yields down further over the short term. However, we remain focused on the medium term when we expect moderate economic recoveries, money supply growth, and large financing needs of their governments to push government bond yields up. We are positioning to benefit from rising interest rates in select economies. The different paces at which economies are recovering have necessitated different monetary policy responses. This is leading to increasing interest rate differentials, which we are capitalising on through currency exposure.
One example of this is our negative Japanese yen positioning against the US dollar, based on the expectation that interest rates and yields will rise in the US ahead of Japan. Japan continues to suffer from deflation and weak domestic demand, so even if interest rates stay relatively low in the US for a while, the moderate recovery in the US will eventually lead to an increase in the interest rate differential. Picking inflection points precisely is very difficult and consequently we may miss out on the very last stages of the rally in government bonds. However, we remain committed to our fundamentals focused, medium term approach.
Jon Day, Fixed Income manager at Newton
Bond yields have fallen across the curve towards or through their 2008 lows. The difference this time is that a dramatic slowdown in growth similar to that expected in Q1 2009 is not as widely forecast. Also, the number of policy options available to the authorities if the economy does falter is now severely limited. The fiscal stimulus option is no longer available and actually it is going into reverse. The Europeans are in full fiscal austerity mode and the US have their version in the form of State balanced budget controls that will force them to tighten this year.
With mortgage arrears in the U.S. running at close to double digits and unemployment stubbornly high a modest economic slowdown could easily turn into something more serious especially with the lack of fiscal support.
Therefore, the authorities are likely to have little choice but to relax monetary conditions further with quantitative easing the most likely option.
This provides a very positive momentum for government bond markets, core inflation is low and unlikely to rise, issuance should fall as austerity measures means governments will be borrowing less and the expansion of central banks’ balance sheets together with the existing increase in domestic savings will underpin demand.
This provides a very good platform for yields to fall further.
Philip Laing, head of rates, Standard Life Investments
The obvious answer has to be yes. We are in unprecedented times where the normal rules of the economic cycle may not operate. Signals of economic drag have prompted a savage decline in bond yields with US 10 year yields down 150bp since April while UK and German bonds have surged to new cyclical lows. A double dip is being priced. This is not our central scenario. The global recovery may well be below par with signs of faltering momentum, especially in the US, but monetary conditions stay exceptionally supportive. However, US housing and high levels of personal debt remain problematic. The former remains ground-zero for this crisis with a high level of distressed sales undermining prices and confidence. The latter is resulting in a desire to increase savings and lowering credit demand. Both impact company intentions to invest and employ.
In part, the bond surge is in anticipation of further exceptional stimulus measures, the much vaunted quantitative easing. However, there is also an underlying fear that economies may well be suffering ‘Japanification’ whereby growth fails to respond and the economic cycle becomes highly protracted. This certainly explains the extent to which short interest rate expectations have been crushed.
Ultimately signs of stutter have been extrapolated into a crisis in the bond markets due to a combination of thin summer markets and speculation. For now, lower yields seem the path of most pain to investors – this is not yet a bubble. However, the test will be whether yields are supported by economic developments with the irony that by being so low they are providing their own economic boost.
