In 2007/08 World stock markets were pushed too close to the sun by the spiralling shadow banking markets. In 2011/12 gold and commodities, spurred by soaring Central Bank liquidity, followed. Now, driven by a scramble for ‘safe’ assets, it is the turn of government bond markets. Ironically, their term premia have been driven to such low extremes they now look more like risk assets than ‘safe’ ones. In this topsy-turvy World, investors have been buying bonds for capital gain and equities for yield. Treasuries look vulnerable to both domestic inflation shocks and global capital flow shocks.
We have changed our view on global bonds. Having being resolutely bullish, even a year ago, we now believe that US bonds are a bubble and non-US bonds are very expensive and not worth buying. Experience shows that the slope of the interest rate yield curve is a sound guide to future excess returns from investing in Treasuries: the steeper the better. This fact follows from the observation (supported by data from the New York Federal Reserve) that as much as three-quarters of the variation in the yield curve slope derives from ex ante term (or risk) premia movements, rather than from changes to policy interest rates as the textbooks alternatively claim. A 50bp positive term premium on a 10-year bond means that the investor picks up this additional yield on top of the compound return from rolling a one-year Treasury each year over the 10-year horizon. Because the ‘real’ term premia components (taking out the effects of inflation trends) are mean-reverting, periods of large term premia and steep yield curve slopes ebb and flow cyclically. This facilitates alpha-generating fixed income investment strategies of buying high premia and selling low premia.
Yet, many bond investors traditionally ignore the message coming from term premia simply because traditionally in a World of moderate nominal yields, i.e. circa 5-6%, a premium that averages 50bp and fluctuates with a standard deviation of 75bp, may spoil your day, but not ruin your career. But with the 10-year Treasury yield base now nearer 2%, these same parameters could lead to sizeable and potentially damaging swings in bond prices.
Government Bond ‘Real’ Term Premia – US and G4 Average
CrossBorder Capital, US Federal Reserve, Bank of Japan, ECB, IMF
US Inflation Expectations (10-year Bond) and US ISM Prices Paid
CrossBorder Capital, US Federal Reserve
Figure 1 shows the recent history of 10-year real term premia for the US Treasury and G4 (average of US, Eurozone, UK and Japan) markets. The data are confirmed to be highly cyclical. ‘Real’ term premia average around 33bp for the US Treasury market (standard deviation 73bp) and 43bp (standard deviation 63bp) for the G4 average. They appear to cycle every 7/8 years. The ‘normal’ range for US Treasury real term premia is minus 100bp to plus 150bp, and for the G4 it is minus 50bp to plus 150bp. Given latest data, it is safe to conclude that at minus 36bp the G4 10-year bond currently looks richly priced, and at minus 116bp the 10-year Treasury looks extremely expensive.
But what also matters here are the factors that could drive these term premia in the future. They fall into four categories: (1) inflation risks; (2) shortages of risk assets; (3) investor risk appetite and (4) liquidity/refinancing risks. Aside from the second point which may come under the heading ‘it’s different this time’, the other three factors currently look bearish for bonds. Here, attempts by governments to restrict the size of budget deficits and to force banks and long-term investment funds to hold more Treasury debt through new regulations, plus the ‘buying-in’ of debt by Central Bank QE policies have focussed attention on this ‘supply shortage’ question. Clearly, a prospective supply shortage matters, but in our judgement this factor is already priced in.
The other three factors unambiguously weigh down on bond prices. First, future inflation risks have been heightened by the rebound in crude oil prices and latest US business surveys not only show a recent sharp jump, but importantly they traditionally correlate closely with the inflation expectations embedded in bond markets. See Figure 2. The recent move in the inflation survey could force up US inflation expectations by 50-100bp over coming months.
Global Investors’ Risk Appetite Index
China Cross-border Flows Index and G4 ‘Real’ Bond Term Premia
Second, investor risk appetite measures across the majority of World asset markets remain remarkably depressed. Traditional advisor sentiment gauges currently deliver similar results. It may be explained by the collective skittishness of investors who seem nervous about fragile economic prospects, but we have also added OECD GDP growth to Figure 3. Our risk benchmark highlights that current levels of investor pessimism would imply a severe and unlikely upcoming recession. Other data agree that prospects are not this bleak. As noted, when investors buy bonds for capital gains and equities for yield, something looks wrong!
Third, consider liquidity and re-financing risks. Our research frequently notes the tight positive co-movement between the inflow of liquidity into bond markets and the slope of the interest rate yield curve and, therefore, higher bond term premia. Digging deeper, we find that two components are especially important: (1) bond term premia are driven up by the supply of domestic liquidity because more liquidity reduces re-financing risks and boosts the attractions of traditional risk assets, like equities, over bonds. And (2) the demand for bonds as ‘safe assets’ by foreign investors through heightened inflows of cross-border capital flows can simultaneously drive down term premia.
Latest data make a plausible case that domestic liquidity levels across the major economies look deserving of slightly higher bond term premia. However, the dominant force may prove to be a sharp reversal in cross-border flows into the major bond markets. For example, 2015 saw huge net capital outflows from China totalling some US$850 billion that depleted their forex reserves by a whopping near-US$½ trillion. We believe that the bulk of this cash outflow was flight capital that sought out the safety of Western bond markets. The data reported in Figure 4 highlight the close correlation between a simple ‘normalised’ index of cross-border flows into or out of China and G4 ‘real’ term premia for 10-year Treasuries. On the basis that what goes up must come down, any mean-reversion or normalisation of Chinese capital flows must put sizeable upward pressure on term premia and, hence, bond yields.
Taken overall, the risks to G4 bond markets appear high. It is worth noting that a year ago when many investors were fearful of a ‘bond bubble’, not only were bonds significantly less expensive than they are now, but the future drivers of these term premia and, particularly, inflation expectations/ falling crude oil prices and on-going Chinese capital flight strongly supported bond prices. This is no longer true. If history is any guide, it suggests that ‘mean-reverting’ G4 real term premia (10-year tenor) could increase by 100bp over the next two years, with US real term premia rising by more. This conjecture even ignores the impact of rising inflation expectations which, although admittedly slower-moving, could themselves add another 50-100bp to yields. The conclusion is to radically cut back duration and move away from the US Treasury market.