Anatomy of the escalating bond bear market
The global economy remains in the strong, synchronised upswing that has now been in place for almost two years. The latest Fulcrum nowcasts show no sign of any major slowdown in the global growth rate, which remains around 4.5 per cent, almost a full percentage point above its long term trend. Among the major blocs, the advanced economies are continuing to record growth rates that are, remarkably, 1.7 percentage points above trend, while the emerging markets are hovering around trend.
The recent surge in global growth is mainly a cyclical demand phenomenon, which has so far had only a moderate impact on long term sustainable growth. Although this implies that excess capacity in the world economy is now being absorbed fairly rapidly, there has been very little, if any, increase in underlying core inflation, which remains stubbornly low in the major advanced economies. Headline inflation has risen slightly, because of rising oil prices, but this will not be of any great concern to the central banks. Nor, in itself, should it be of any great concern to the markets.
Based on incoming economic data, the world economy (and asset markets) are therefore still in a regime that we have named “global expansion”, rather than “global reflation” because core inflation remains so subdued. The mix between real output and inflation in nominal economic activity is still extremely healthy:
Despite the low rates of recorded inflation, the global bond market has responded to the acceleration in output growth with a sharp sell-off, especially at the front end of the curve. For example, in the latest phase of bear flattening starting in early September 2017, the US 2-year yield has risen by about 90 basis points, while the 10 year yield is up by 70 basis points. Why has this happened?
Flatter curves indicate that more central bank rate hikes are now priced into the market in the next few years, though the terminal level of equilibrium short rates (r*) a long way into the future has not risen very much (at least until very recently). The markets are therefore pricing earlier monetary tightening, rather than a greater overall amount of tightening by the time the Fed reaches its final destination for this cycle.
Even though the end point for the Fed still seems fairly well anchored, many commentators are now suggesting that the global bond market has entered into a major bear phase, with the decades-long downtrend in 10 year yields now having been breached. Furthermore, these fears are now clearly starting to wobble the equity markets.
A sustained further bear market in bonds requires, by definition, one or both of the following developments: a continued upward adjustment in the expected path for Fed rate hikes, and/or an increase in the term (or risk) premium on long bonds .
The following graph shows how these two variables have behaved in the US 10 year nominal bond market since 2010.
The key point is that the expected path for Fed short rates (in published forecasts by economists, not in the forward curve in the bond market itself) has barely changed in the past 12 months. The FOMC has raised rates broadly as anticipated, and has shifted its forward guidance about future rate hikes only very slightly in a hawkish direction. Therefore, the bond sell-off has occurred because the term premium has increased, not because the consensus view about Fed policy has changed.
Since mid 2016, the term premium has risen by around 100 basis points, which is roughly the same as the increase (albeit over a shorter period) in the taper tantrum of 2013. The premium is now as high as it has been at any time since the Great Financial Crash. It can be argued that the end of global quantitative easing is now fully priced into the term premium at these levels.
We can investigate the anatomy of the recent bear market further by splitting the nominal yield graph shown above into its real and inflation components. Together, the real components and the inflation components add up to the nominal yield, the nominal term premium and the path for nominal expected short rates respectively. Here are the real components of the graph:
And here are the inflation components:
Since the overall bear market in US bonds started in mid 2016, the 10 year yield has risen by 130 basis points, from 1.5 per cent to 2.8 per cent. Most of this increase has been due to a rise in the nominal risk premium, and by far the majority of the increase in the nominal risk premium has come from the inflation component, with the real component rising only slightly.
What has happened, therefore, is that the tail risk of deflation that was being priced into bonds in early 2016 has gradually disappeared, and the inflation risk premium has returned to a fairly normal level around zero. All this has happened while the core inflation rate, and the expected path for future inflation, has barely increased at all. The recovery in real output growth (and commodity prices) seems to have reduced the market’s fear of future deflation, and that is what has driven the bear market in bonds.
So how could this get worse, and develop into an escalating bond bear market, on top of what has happened already?
- The expected forward path for short rates could be accelerated because the Fed becomes more hawkish, more rapidly, than previously expected. This is unlikely, unless incoming inflation data rise markedly.
- The terminal interest rate expected for the tightening cycle could increase, implying that the market has changed its estimate of the equilibrium interest rate, r*. This would require an upward shift in the market’s assessment of long term sustainable output growth, which has not happened yet.
- The term premium on the long bond could rise further, as investors demand more compensation for holding duration risk in the market. A possible cause of higher risk premia could be the elevated US budget deficit at a time of full employment and the planned drop in the Fed’s bond holdings.
In summary, the bond bear market has so far been due to a normalisation of bond term premia, especially the inflation risk premium. With term premia now back to “normal”, bonds look better underpinned than in the recent past. If the bond bear market is to be extended much further on a sustainable basis, something new needs to go wrong in the global economy.
 These calculations have been provided by my Fulcrum colleague Juan Antolin-Diaz. The term or risk premium is defined as the difference between the bond yield over any duration and the expected return from successive investments in short rates over the same duration. It represents the expected excess return from bearing duration risk. This excess return can be positive or negative, depending on investor’s risk appetite and the type of shocks that are expected to prevail in asset markets.