So far in 2014, more than 90 per cent of the bonds issued by the US Treasury have been absorbed onto the balance sheets of the US Federal Reserve, the Bank of Japan and the People’s Bank of China. This degree of incursion into such a critical market is unprecedented and is one of the reasons why US bond yields have been falling relentlessly this year.
Underlying momentum in the US economy is reasonably strong at present. Nominal GDP growth has been north of 5 per cent in three of the past four quarters and in spite of a poor Q1 has remained above 4 per cent year-on-year. The annual trend in inflation has accelerated towards the Fed’s 2 per cent target and the headline unemployment rate has fallen towards its historical long-term average of around 6 per cent.
For five decades, the 10-year US Treasury yield has moved between 70 per cent and 140 per cent of the growth of nominal GDP. Assuming a trend rate of 5 per cent nominal growth is plausible for this year and into next, the above rule of thumb suggests bond yields should be north of 3.5 per cent at present (5 per cent times 0.7).
This is the primary reason we remain fairly cautious of almost every asset class.
A move in the 10-year Treasury from 2.4 per cent to 3.5 per cent would incur a capital loss close to 10 per cent while the total return would be a loss of about 7 per cent. Returns for higher-risk fixed-income assets may be much worse, not because of an immediate deterioration in credit fundamentals but more due to the illiquid nature of credit markets since the financial crisis.
Earlier this quarter we discussed with a top-tier UK credit fund manager the structure of their market and the risks beyond credit fundamentals. Their view is the secondary market for corporate credit is close to non-existent. Our view for some time has been that this is an underappreciated risk and one that may come home to roost once expectations shift durably on the direction for interest rates. In their words, it could be a “bloodbath”. No doubt that would surprise many in the context of an improving economy.
We hope for a different outcome than falling bond yields and rising equities. We hope the Fed is closer than the market suspects to normalising monetary policy. Although there would be a period of disruption for some overpriced markets, asset class valuations would likely improve to more sustainable levels. With the economy in reasonable shape, that would offer investors genuine cause for optimism.
We may have to remain patient for a little longer but sooner or later, if the economy and labour markets continue to improve as we expect, remaining at emergency levels of policy accommodation will begin to threaten the credibility of both the Fed and the Bank of England.
Robin McDonald is a member of the multi-manager team at Schroders