Turn down the noise to understand what’s happening in the bonds market

As tends to be the case with headline market events, it’s important to view them in context and with due credit to history. The bonds market in 2021 is no exception.

“With apologies to Warren Buffet, it’s not just the share market that can be described as manic depressive, but financial markets in general,” says Shane Oliver, chief economist of AMP Capital.

“Just a year ago, investors were worried about depression and deflation with bond yields and share markets plunging. Now they’re worried about overheating and inflation with bond yields rising rapidly, causing agitation in share markets.”

Oliver has a point. Economists are known as dismal scientists. But maybe investors should be included as well.

A history lesson first. Warren Buffet, the so-called Oracle of Omaha and among the world’s most successful investors, was a disciple of Benjamin Graham, who in 1949 published The Intelligent Investor – the most famous book ever written on investing. Graham invented the idea of Mr Market – an investor who was driven by panic, euphoria and apathy, on any given day. That’s what Buffet means when he talks about markets being manic depressive. And in Oliver’s eyes, there’s just a touch of that going on in markets at the moment.

“From their lows in March, April of last year, 10-year bond yields have now increased by around 0.9 per cent in the US and one per cent in Australia,” Oliver explains. “And a rise in bond yields means a fall in bond prices or a capital loss.”

The rise in yields reflects confidence in the economic recovery. The roll-out of vaccines and massive policy stimulus in the US has convinced some investors that the Fed will have to tighten monetary policy, by lifting interest rates, earlier than planned. And there’s a whiff of inflation around, which has also pushed up yields.

Higher energy and raw material costs and supply bottlenecks will push up goods prices, and given this year’s data will be compared to price falls 12 months ago, the headline numbers could be high.

“We will likely see annual headline inflation measures rise to around 3.5 per cent to four per cent by mid-year in the US and Australia,” Oliver says.

Bond yields normally rise during economic recoveries

When an economy is recovering, investors switch out of safe-haven bonds, and invest in growth assets like shares, Oliver says.

“It’s normal. Bond yields rose after the early 1990s recession, in the mid-2000s after the Tech Wreck, and after the 2011-12 growth slowdown. They also rose after the 2015 global growth scare,” he says. “The latest move is not unusual historically, although it has been very rapid this year.”

Are higher bond yields a problem for shares?

At its most basic, lower bond yields are good for shares because they make investing in equites relatively more attractive. The opposite occurs when bond yields are higher.

“But it’s never quite that simple as it depends on what happens to company profits,” Oliver says.

“As we saw last year, a collapse in earnings expectations and share prices can occur alongside a plunge in bond yields.”

The key factor is whether the return on offer from shares is enough above the return on bonds, given that equities are riskier.

“Despite the rally in shares since their lows in March last year, and the recent rise in bond yields, shares still provide a decent risk premium over bonds,” Oliver says.

“In other words, bond yields have risen and so too have earnings expectations, by 13 per cent in the US and 12 per cent in Australia since mid-January.”

Do bond yield spikes hit some sectors harder than others?

In short, yes, says Oliver. “Particularly at risk are tech and health care stocks that will experience less of a cyclical uplift in earnings, and trade on higher price-to-earnings multiples,” he explains.

These stocks’ share prices rely more on earnings in the future. They are called ‘long duration’ stocks. Calculating the future profile of earnings involves bond yields, and if yields are higher, the value of future earnings is lower.

“Also at risk are stocks that normally have higher yields. There was a search for yield flowing from falling interest rates and bonds yields, and that helped telcos and utility stocks,” Oliver says.

“But cyclical stocks like materials, retailers, industrial and even financials are less at risk as their earnings will rise more with the economic recovery. They are more likely to see earnings upgrades,” he says.

Undoubtedly some bond crashes have led to share markets tumbling, notably in 1994 when the local equity market ultimately fell 22 per cent. The economic recovery from the early 1990s became entrenched, and central banks lifted interest rates. The Fed hiked and then the RBA increased the official cash rate from 4.75 per cent to 7.5 per cent over a short period and the share market tumbled.

Again in 2013, bond yields rose sharply after the Federal Reserve in the US said it would slow bond purchases at a time when investors were still uncertain about growth. Wall Street fell eight per cent and the ASX was down 11 per cent.

The 1994 bond crash, and the ‘taper tantrum’ in 2013 were temporary, but both triggered a sell off on share markets.

“Today is a bit different because the recovery is less advanced than in 1994 or 2013, and central banks are not tightening or contemplating tightening,” Oliver says.

The central banks have learnt their lessons

Central banks are full of smart people and the lessons of 1992 and 2013 have been well learnt, Oliver says.

“The Fed and RBA fear that bond markets are jumping at what will be a transitory hike in inflation over the months ahead as the deflation from a year ago drops out and higher commodity prices and goods supply bottlenecks impact,” Oliver says. “Rather than repeat the mistakes of previous times where central banks tightened only to see growth slow again and inflation remain below target, they would rather look through any short-term spike in inflation.”

In recent months central banks from the US to Japan, Europe and Australia, have worked hard to either boost bond buying to keep a lid on short-term rates, or use speeches to emphasise that there was still a long way to go in the economic recovery, Oliver says.

“There’s been more push back from the central banks. The Reserve Bank has stepped up the pace of bond buying to maintain its 0.1 per cent target [for yields on three-year bonds] and brought forward purchases of longer-term bonds. Governor Philip Lowe said he would do more if needed¹.

“The central bank’s focus is to allow the recovery to reduce the number of unemployed and underemployed workers. They want to see much higher wages growth before tightening, and that might be several years away,” Oliver says.

Is it business as usual?

While the rise in inflation over the next couple of months will in all probability be transitory, it is possible that the world is coming to an end of a 40-year period of a declining trend in inflation and falling interest rates.

“There’s a strong case to be made that the disinflation seen since the 1970s is coming to an end and that the long-term trend in inflation is at or close to bottoming,” Oliver says. “Central banks are now throwing the kitchen sink at beating deflation and disinflation, just as they threw it at high inflation in the 1980s and early 1990s.”

Oliver says there is now a possibility that massive government spending, more interventionist government policies, a reversal in globalisation and a decline in the number of workers, relative to consumers combined with aggressive central bank reflation, will defeat deflation and disinflation. The fiscal stimulus in the US in 2020 and 2021 will amount to about 23 per cent of gross domestic product – the largest since the Great Depression.

“Ultimately that could result in a sustained rise in inflation, though that is probably still a few years away. But it is consistent with the notion of the 40-year bond bull market in bonds being over. That means the bond sell off is quite possibly the start of a longer-term rising trend in yields,” Oliver says.

“But as with inflation bottoming, this will take years to play out in the bond market.”

What’s the bottom line for investors? In the near-term bond yields could still go a lot higher before they fall back again. That could cause the long overdue correction in the equity market, Oliver says. “But the big cyclical backdrop for the next 12 months or so of still low underlying inflation and spare capacity in the jobs market, combined with economic and profit recovery and low interest rates is a positive one for growth assets.”

1. www.rba.gov.au