Rising yields and market sensitivity

The markets are in the midst of a strong reflationary trade, with most investors convinced that global growth is accelerating, inflation is starting to rise and the dollar will strengthen. With the election of Donald Trump as US president, investors believe he will cut taxes, boost infrastructure spend and cut red tape. With a strong pro-business agenda, we will see accelerating US growth or so goes the narrative.

One of the natural outcomes of this reflationary trade is the rise in bond yields. If growth and inflation are both accelerating, bond yields will rise. This is especially so given the extraordinary monetary accommodation and unconventional interest rate policy of the past few years. We have already seen US 10-year yields rise to 2.6 per cent. Some of the more bearish commentators expect a quick surge to 3 per cent, with an eventual convergence to nominal gross domestic product (GDP) growth, likely to be somewhere near 5 per cent. The 35-year bond bull market looks to be over. Their outperformance versus equities over the past 17 years seems destined to end.

Independent of this, a corollary is the impact of rising yields on economic growth itself. Debt ratios and absolute debt numbers globally are at very elevated levels. The sensitivity of economic growth to rising bond yields should be at an extreme. This dynamic of elevated debt cannot withstand high rates, as servicing costs will get to a point where they trigger a recession. Will the near 100 basis point rise in yields till date be enough to short circuit economic growth? At what point should we be worried? The reflationary trade will fall flat on its face if rising yields linked to accelerating growth and inflation themselves stall growth.

BCA has done some interesting work in this area, and come to the conclusion that rising yields are not an issue in the short term at least.

They acknowledge that globally debt levels are at an all-time high. Since 2007, global debt has surged by 40 per cent to over 250 per cent of GDP (household, corporate and government). Given this level of debt, simple back-of-the-envelope calculations, assuming a 100-200 basis points rise in servicing costs throw up very worrying projections. The cash flow effect of rising debt service costs is enough to seriously damage both consumption and investment. Many of the bears on the US, and the current rally believe that markets are overestimating the potential growth acceleration in the economy as the bulls are failing to understand the cash flow drag of rising interest rates.

BCA makes the point that these back-of-the-envelope calculations are too simplistic and the impact is far more nuanced. They are less bearish on the cash flow impact of rising rates than most. They have looked at data in the US, the UK, EU and Japan.

Their more sanguine view is based on the fact that debt service burdens are today far lower than in 2007, across all geographies studied, with the decline in rates more than compensating for the rising debt stock. The starting point on debt service is very low.

Second, the maturity profile of the debt implies that it will take a long time for rising rates to actually impact debt servicing costs. Corporate debt has a maturity profile of mostly between 5 to 12 years and most governments have extended their debt maturity to over 10 years. For households, almost 90 per cent of consumer debt is fixed rate, thus insulated from short term interest rate fluctuations. 

They make the additional point that even today, across all geographies studied, the average cost of existing debt stock, across all types of borrowers, is higher than current interest rates. Implying that as this debt matures, is replaced with new debt at current rates, servicing costs will actually decline, as the debt stock gets re-priced downwards.

Based on the above factors, their modeling shows that even if interest rates were to rise by 100 basis points immediately and across all maturities, it will not materially damage the cash flows of any category of borrowers over the coming two to three years. The increased debt service will be very much in line with previous tightening cycles and still take the debt service burden to levels lower than prevalent prior to 2007. You need a 300 basis points immediate rise in rates across the yield curve to start causing damage to spending. 

While we do agree that the bond bull market is probably over, the chances of an immediate rise of 300 basis points in yields across the maturity curve looks to be remote. Inflation across all the major economies is still benign, and bond supply will likely continue to mopped up the Bank of Japan (BOJ) and the European Central Bank (ECB). Market experts expect the stock of government bonds available to investors to actually shrink by $750 billion in 2017, after already shrinking by $546 billion in 2016. Guidance provided by the BOJ and the ECB, in terms of continued QE and a targeted level of interest rate will also cap bond yields globally.

Illustration by Ajay Mohanty

Despite the surge in debt after the financial crisis, it does not seem that rising debt service costs can short circuit the global economy as the Fed normalises monetary policy and interest rates globally mean revert. Even if rates rise by 100 basis points, debt service will rise from very low levels and the increase in interest payments/GDP will be consistent with previous cycles. The level of interest/GDP will also be within the levels seen in 2007.

While the outlook for the reflation/Trump trade is murky on various levels, most certainly on the president being able to deliver on his legislative agenda, the trade will not collapse because of rising rates. Unless rates spike much higher than anyone expects, this will not kill the rally.

The only caveat to all this is China. The debt numbers there are truly scary, especially on the corporate side. Debt has gone up to 170 per cent of GDP from 100 per cent in 2008. There isn’t enough granular data to do a similar analysis for China as done above, but clearly it is much more vulnerable than other developed market economies. China and its corporate debt ratios remain the Achilles heel of the global economy. An implosion here could bring everyone down.
 

The write is with Amansa Capital. Views are his own