What Happened to the Bond Bear Market?
Slowing growth outside the United States and escalating trade conflicts are calling into question the strength of the global expansion.
While China has taken steps to boost its economy and let the yuan drift lower against the dollar, if the U.S. dollar continues to rally it will mean tighter financial conditions globally.
Federal Reserve tightening has helped tame expectations for long-term inflation, helping to keep longer-term yields in check.
Bond bear market—paused or over?
For nearly two years, 10-year Treasury yields marched steadily higher, supported by improving global growth, prospects for fiscal stimulus to boost the domestic economy, and steadily rising inflation. Add into this mix the Federal Reserve’s rate hikes and balance sheet reduction, and it looked like the bond bear market would continue through 2018.
After rising from 2016 to 2018, 10-year Treasury yields have leveled off recently.
Source: 10-Year Treasury Constant Maturity Rate, Percent, Monthly, Not Seasonally Adjusted (DGS10). Data as of 7/5/2018.
However, the bear’s progress seems to have halted. After reaching a seven-year high at 3.12% in mid-May, 10-year Treasury yields have declined, falling back to the 2.8% area even as the Federal Reserve raised short-term interest rates twice this year. Consequently, the yield curve—the difference between short and long-term yields—has flattened, with the difference between 10-year Treasury yields and three-month Treasury bills declining to the lowest levels in a decade, something that typically occurs late in the business cycle.
The difference between 10-year and three-month Treasury yields has declined.
Source: Federal Reserve Bank of St. Louis. 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity, Percent, Daily, Not Seasonally Adjusted. Monthly data as of 7/5/2018.
We still see the potential for bond yields, which move inversely to bond prices, to rise back into the 3% to 3.5% region in this cycle, as U.S. economic growth benefits from fiscal stimulus, inflation continues to pick up and the Federal Reserve winds down its balance sheet. However, there are three significant risks to this outlook:
1. Fading global expansion
Growth outside the U.S. has slowed since the start of the year, calling into question the strength of the global expansion. While there are signs of a rebound in Europe from a slump in the first half of the year, China’s efforts to tighten up on lending in the private sector due to its debt overhang could mean slower growth in Asia. Emerging market countries in the region with close trade relationships with China are the most vulnerable to a slowdown.
The OECD’s composite leading indicator suggests growth outside the U.S. may be slowing.
Source: OECD as of April 2018.
What to watch: China’s domestic financial policies and the trend in the U.S. dollar are bellwether indicators for global growth. On the positive side, China has reduced short-term interest rates and allowed its currency to drift lower. It has also begun to loosen up on lending restrictions to give its economy a boost. If these trends continue, then the value of the yuan versus the U.S. dollar is likely to decline further and the slowdown probably will be short-lived. On the negative side, the dollar has already rallied by more than 7% against major trading partners from its lows in February. If it continues to rise, it will mean tighter financial conditions globally and likely put more downward pressure on emerging market countries and companies with large U.S. dollar-denominated debts.
The Goldman Sachs Financial Conditions Index shows financial conditions have tightened this year.
Source: Bloomberg. Data as of 7/5/2018.
2. Trade conflicts
With trade conflicts ratcheting up in the past few months, there are concerns about the potential for slower growth. The minutes of the last Federal Open Market Committee meeting cited these concerns, with the Fed noting that some businesses have already reduced or postponed investment due to uncertainty about trade policy. Recently, the U.S. followed up on its promise to put tariffs on another $34 billion in Chinese goods, adding on to the steel and aluminum tariffs previously imposed more broadly. Other countries have responded with countering tariffs. There is a risk that a trade war will disrupt global supply chains and dampen business investment and economic growth. Tariffs also tend to raise inflation by increasing the cost of imported goods. However, the inflation impact on bond yields is likely to be less significant than the potential to slow economic growth.
World gross domestic product has tended to track trade volume.
Source: International Monetary Fund, World Economic Outlook Database, world gross domestic product and world trade volume of goods and services, annual data as of December 31, 2017.
What to watch: In addition to actual news about trade conflicts, business sentiment indicators about investment are a key metric to assess the impact of tariffs. To date, business confidence indicators have been resilient, benefiting from incentives provided in this year’s tax bill. If there is a downshift in confidence, it would likely signal less investment and hiring.
3. Fed policy
Ironically, the tightening in monetary policy by the Federal Reserve is also contributing to keeping bond yields low. While many investors think that yields inevitably rise as the Fed tightens policy, that isn’t necessarily the case. Short-term interest rates move up when the Fed tightens, but long-term yields are driven primarily by inflation expectations.
Even though inflation has been rising and recently reached the Fed’s 2% target based on the core PCE index, inflation expectations have remained tame. The surveys for the University of Michigan Consumer Sentiment Index show that while consumer expectations for inflation over the next year have risen, there hasn’t been much increase in expectations for longer-term inflation.
Consumer expectations for inflation in five to 10 years are relatively subdued.
Source: Thompson Reuters/University of Michigan. Data as of 6/29/18.
Subdued inflation expectations are not too surprising, because the Fed’s inflation-fighting credibility means when it starts tightening policy, markets expect growth and longer-term inflation to slow. Currently, market expectations for the path of the federal funds rate are lower than the median projections provided by the Fed. The two-year forward rate for one-month interest rates—that is, the short-term interest rate that market participants generally expect to see two years from now—is 2.6%, compared with the Fed’s median estimate of 3.4% for 2020.
Market expectations are up, but still well below the Fed’s median projection.
Source: Bloomberg, USD OIS Forward Swap, S0042FS 2Y1M BLC Curncy. Data as of 7/9/2018.
We expect the Fed to continue on its steady course until it gets the federal funds rate closer to the “neutral” level, in the 2.6% to 3% region. Although the median estimate for 2020 suggests a funds rate of close to 3.4%, it would not be surprising to see those estimates retreat.
What to watch: The slope of the yield curve, along with inflation expectation indicators, can be good signals for determining how high longer-term bond yields are likely to go. With the yield curve steadily flattening and inflation expectations holding steady, 10-year bond yields may struggle to return to this year’s highs.
Ten-year Treasury yields have been rising for two years, from a low of 1.35% in mid-2016 to a recent high of 3.12%. While the Fed may continue to raise short-term interest rates over the next year or two, long-term bond yields may be in the process of peaking, especially in light of the growing list of downside risks to inflation and economic growth.
We continue to suggest investors maintain average portfolio duration in the short to intermediate term—specifically the two- to five-year range—where the risk/reward trade-off looks most attractive. However, in the second half of the year, higher volatility and rising economic risks may steer global investors toward the Treasury bond market, raising prices and limiting the rise in long-term bond yields. In other words, while we’re not quite ready to suggest adding duration to portfolios, if you are inclined to buy longer-term bonds there’s probably little reason to fear making such an investment.
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Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
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The Organisation for Economic Co-operation and Development’s (OECD) composite leading indicator (CLI) is designed to provide early signals of turning points in business cycles showing fluctuation of the economic activity around its long term potential level. CLIs show short-term economic movements in qualitative rather than quantitative terms.
The Goldman Sachs FCI is a weighted sum of a short-term bond yield, a long-term corporate yield, the exchange rate, and a stock market variable. The Federal Reserve Board’s macroeconomic model together with Goldman Sachs modeling, were used to determine the weights. An increase in the Goldman Sachs FCI indicates tightening of financial conditions, and a decrease indicates easing.
The core PCE price index is defined as personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.
The University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan. Each month at least 500 telephone interviews are conducted of a continental United States sample (Alaska and Hawaii are excluded). Fifty core questions are asked.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.