Abrupt Start To A Gradual Bear Market in Global Fixed Income
There are always fears among investors when monetary authorities (especially at the Fed) consider shifting to a less dovish stance. However, there is a profound difference between scaling back quantitative easing and tightening. The Fed will begin tapering this year (in line with the improvement in domestic growth), but rate hikes are still a long way off. The central bank is determined to keep interest rates (or the cost of borrowing) below economic growth (or return on investment), in order to support a sustained economic expansion.
Importantly, most other major central banks are not willing to deviate materially from Fed policy. At the moment, excess capacity in the global labor markets has created a deflationary shock in terms of consumer inflation. Because CPI baskets now tend to include more items with globally set prices, inflation is decisively below target in nearly all economies. This provides most central banks with flexibility in terms of exiting the great monetary experiment and nearly all global policymakers are taking advantage of this by keeping rates anchored and global liquidity plentiful.
Given this backdrop, it is natural that investors question why bond yields have backed up so sharply this year. The answer is that they had an extremely distorted starting point. Using the U.S. market as an example, the MRB Government Bond Valuation Model (which incorporates a relatively subdued recovery and lingering disinflationary pressures) indicates that fair value of 10- year Treasury yields is currently about 3%. We can knock this down by about 10-20 bps if we assume that the Fed stays on hold throughout its conditional guarantee and then tightens in mid-2015 by 25 bps per meeting until it hits 4% in mid-2017.
Thus, Treasury yields (along with yields in most other “high quality” government bond markets) bottomed in mid-2012 well below the level dictated by underlying fundamentals. The only way that the lows in bond yields could have been sustained is if the economy remained so depressed that the central bank was forced to continue aggressively buying bonds over the next few years. Once the Fed openly considered tapering, this distortion began to unwind (both within the U.S. and globally, given that many other central banks have linked their policy to the U.S. in order to mute currency fluctuations). That said, yields are now back in the fair value range.
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Phillip Colmar, MRB – The Macro Research Board