Government Bonds: Not So Vigilant
I have been bearish on government bonds since March this year and have repeatedly warned that they were an overpriced asset class, saying at the time: “… one should be cognizant of the fact that an investment in a 10-year Treasury Note will by definition lock in a total return of 3.5% over the next 10 years. This sounds unsustainable and I find it difficult to see the long-term investment merit of such an investment. Long-dated bond prices could be hit hard once yields adjust to more realistic levels.” (See “Long Bonds in Injury Time”, March 28, 2008.)
Although rising bond yields have been given a reprieve as a result of the deteriorating outlook for economic growth and commensurate safe-haven buying, I maintain that the medium-term outlook remains negative owing to valuation levels still being stretched, especially in the light of mounting inflationary pressures.
The chart below shows the long-term pattern of US ten-year Treasury bond yields and specifically the low of 3.14% reached on March 17 and the subsequent turnaround.
A very apt and well-reasoned summary of the various factors impacting the outlook for government bonds appeared in The Economist a few weeks ago. This article is greatly complementary to my previous posts on bonds and is therefore republished in full in the paragraphs below.
“The yield of Treasury bonds is arguably the single most important indicator in financial markets. Since the American government is unlikely to default, the bond yield sets the risk-free rate against which other assets are measured. It also serves as a barometer of investors’ feelings about economic variables like inflation and recession.
“But precisely because it does so many things, the Treasury bond can send out conflicting signals. Consumers have been grumbling about the inflationary impact of higher oil and food prices for a while. But bond investors have only recently taken fright, pushing the yield on the 10-year Treasury bond above 4% on May 28, for the first time since the start of the year. Even now, however, the breakeven inflation rate (the difference between yields on conventional and inflation-linked bonds) on five-year Treasury issues is just 2.4%, within the range it has occupied for the past four years; compare that with the 7.7% inflation rate that American consumers expect over the next 12 months.
“One possibility is that the ‘bond-market vigilantes’ have been asleep. ‘We sometimes wonder if Treasury-bond investors enjoy losing money,’ muses Tim Bond, a strategist at Barclays Capital, as he ponders the logic of owning ten-year Treasuries yielding close to 4% when headline inflation is heading (on his view) for more than 5% by August.
“Bill Gross of Pimco, a bond-market investor, argues that inflation is understated in the official American figures because of statistical adjustments made over the past 25 years. The result may be that investors have been fooled into buying Treasury bonds on unrealistic expectations of real (after-inflation) yields.
“Another possibility is that breakeven rates are not an effective measure of investors’ inflation expectations. That is the view of Jack Malvey, a strategist at Lehman Brothers. He argues that yields on inflation-linked bonds have been distorted over the past decade by demand from pension funds, which see the bonds as an ideal way to match their liabilities.
“A third option is that bond investors think today’s inflation rates are a blip. ‘Inflation may be an issue now but it likely won’t be over the next ten years,’ says Pavan Wadhwa, head of European rates strategy at JPMorgan Chase. Optimists argue the anti-inflation credibility of central banks is stronger than in the 1970s. And they note that high oil prices, although they push up inflation in the short term, ultimately tend to act as a tax on growth.
“The credit crunch may also be having lingering effects. Bond yields reached their low in mid-March when the Bear Stearns crisis was in full swing. At that point, the ten-year Treasury bond yielded just 3.31%, the lowest level in five years. Investors were fleeing the riskier debt of bank and other corporate borrowers for the safety of government paper.
“Yields have moved up by more than half a percentage point since then, as investors have started to move money out of government bonds and back into the equity market. But recessionary fears still linger, especially when investors are bombarded with statistics such as the continued fall in American house prices and the decline in consumer confidence. It may still be worth holding Treasury bonds yielding around 4% as a hedge against a sharp economic downturn.
“In short, the bond market is caught in an awkward compromise, with worries about the financial and economic outlook balancing concern about inflation.
“In the medium term, however, it is hard to argue with Lehman’s Mr Malvey when he says that he expects yields in some government-bond markets to rise by two to three percentage points over the next two or three years. Although the world may not be about to return to the excesses of the 1970s, the Goldilocks era is tapering off: the trade-off between growth and inflation has deteriorated.
“Nor have Treasury-bond investors exactly been coining it in recent years. According to Barclays Capital, the annualised real return since the start of 2003 has been a meagre 1%. Will the Chinese, with a domestic inflation rate of 8.5%, really want to hold bonds yielding 4% in a currency they expect to depreciate against the yuan? Is the anti-inflationary credibility of the Federal Reserve really that convincing when it is clear that its rate decisions can be driven by concern for the health of the banking sector? Indeed does it make sense for German ten-year bonds to yield more than Treasuries when the inflationary rhetoric of the European Central Bank looks much more hawkish?
“Veteran investors may recall 1962, when the Treasury-bond yield was less than 4%. Those who bought bonds then earned negative real returns over the succeeding five-, ten- and 20-year periods. They should be very careful about making the same mistake again.”
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