Today, we have a situation where sovereign-bond yields globally are at extreme levels. In Japan, 10-year sovereign-bond yields are below 0.6 per cent, in Germany they are at one per cent and even in the United States they are at 2.5 per cent - all extremely low yields by historical standards. Two-year yields in Germany and certain other European countries are actually negative. The European Central Bank is charging banks and providing negative interest rates if they place excess reserves with it. Quantitative-easing (QE) programmes were in place in Britain, Japan and the United States, and look likely to commence in the European Union (EU) shortly.
As we look out over the coming years, it is important to have a perspective on where one thinks global sovereign yields will settle. They have to go up from here, for sure, given current levels; but what will be the pace and extent of normalisation?
Are global bond markets poised for dislocation as soon as the central banks cease QE? Are yields poised to spike much higher due to elevated public and private debt levels, or will yields remain depressed as the forces of secular stagnation overpower the end of QE bond buying?
As one tries to project bond yields over the coming years, there are many complex and interrelated factors one will have to take into account. Demographics, central-bank balance sheets, the forces of secular stagnation, declining inflation expectations - each of these factors is important. But how to figure out the relative and shifting importance of these and other variables when looking at prospective yields many years from now?
In a recent report, The Bank Credit Analyst has addressed exactly this question. They have used an International Monetary Fund (IMF) model to try and project yields into the future, as well as try to understand which factors are most critical.
Tracking bond yields globally since 1990, and trying to break down contributions to changes in 5Y/5Y forward rates (five-year yields, five years out), the IMF model throws out some interesting conclusions.
First, demographics have played a very key part in pulling down rates since 1990. The growth in the working-age population has fallen from 0.8 per cent in 1990 to 0.2 per cent today, leading to a headwind in demand for all types of goods and services. This downward pressure on demand resulted in lower interest rates across the yield curve. The slowdown in labour-force growth reduced yields by about 50 basis points between 1990 and 2007, and about 120 basis points between 2007 and 2014. As the demographic profile of most of the developed world continues to worsen, this will be a key factor in preventing rates from spiking in the coming years.
Secondly, QE has been the most important factor for the decline in equilibrium yields since 2007. Going forward, as the QE programmes are unwound it will drive yields higher - but it is critical to understand the pace of central-bank balance-sheet shrinkage. This upward pressure on yields will play out over many years unless the central banks dump assets aggressively.
The third major conclusion of the IMF model and its forecast is that we are unlikely to see a significant rise in equilibrium yields due to a weakening of the fiscal position of most countries for the rest of this decade. This effect becomes far more important as we look at equilibrium yields from 2020 onwards. It is only in this timeframe that the real weakening of government finances becomes apparent, as they have to deal with the social and funding pressures of an ageing population.
The bottom line of the IMF model is that global bond yields should not soar over the coming five years, even though the various QE programmes will be wound down. Fair value for the average five-year forward yield may only rise by about 40 basis points (rising inflation expectations are offset by demographics and improving fiscal health), after falling about 320 basis points since 1990. So some reversal, an end to the bond bull market for sure - but nowhere near the bloodbath the bond bears are expecting.
The only caveat to this is that the IMF modelling assumes that while QE ends by 2014 in the United States and by 2015 in Japan (there is no QE assumed in the EU), the respective central banks will keep the size of their balance sheets unchanged and allow them to shrink as a percentage of gross domestic product (GDP). The bears may argue that this is too modest an assumption, and the balance sheets will actually shrink in absolute terms. Faster normalisation of central-bank balance sheets will drive yields higher.
Beyond 2020, however, the yields may back up more aggressively, with an anticipated 160-basis-point rise. While demographics will continue to put downward pressure on yields, this will be more than offset by the deterioration in government finances and continued shrinking of central-bank balance sheets. It could get much worse, in terms of a greater rise in yields if developed-country governments are unable to get a grip on their finances and their deficits blow up due to spending pressures linked to an ageing population.
The model looks at individual countries and different modelling scenarios. For example, if the EU were to announce a proper QE programme, then yields there would drop to Japan-like levels. If governments are unable to keep their fiscal house in order, then we could see yields rising by another 120 basis points over and above the 160 basis points predicted from 2020 onwards. If the global economy grows one percentage point faster than the IMF model, then yields may rise by 150 basis points more than predicted. These predictions are obviously on a point-to-point basis and yields will, in reality, fluctuate.
While what happens in the coming years is unknown, the point the paper makes is that unless real GDP growth and inflation are much higher than what the IMF is currently projecting, it is unlikely that bond yields will spike dramatically in the coming five years. If the IMF is right, rising yields are not going to torpedo this bull market in financial assets. Something else may, but not a bloodbath in bonds.
The writer is at Amansa Capital