Sometimes, what doesn’t happen is as significant as what does. This is the case with the US bond market. At 2.7 per cent now, five-year US Treasury yields have barely changed in the past three months. This is odd, because several developments should have raised them. Among these are:
- The economy has boomed. Latest official figures show that industrial production rose 1.3 per cent between March and June, more than twice the average growth rate over the past 50 years. Next week’s ISM survey is expected to show that this expansion is continuing.
- The S&P 500 has risen. Increased appetite for risk and higher earnings expectations should raise bond yields by depressing demand for safe assets.
- Core inflation has risen, a fact likely to be exacerbated by President Trump’s decision to raise tariffs – these tend to raise domestic prices, and not just prices of imports.
- Interest rate expectations have risen. Futures markets are now pricing in two more rises in the Fed funds rate this year. This should raise bond yields simply so that bonds remain attractive relative to higher-returning cash.
- Russia has dumped US bonds: they sold $35bn of them in April and May, mostly to offshore hedge funds.
Given all this, you’d expect to see rising bond yields. So why haven’t we?
One reason is that a trade war is ambiguous for them. On the one hand, it raises inflation. But on the other it creates uncertainty about how high tariffs will go, or how much they’ll be imposed upon other goods, and the economic damage this might do. Faced with such uncertainties, some investors want bonds as a safe haven. This safe haven demand has been reinforced by fears that higher interest rates might eventually cause a recession: the best lead indicator of such an event is an inversion of the yield curve (whereby long-dated yields are below short-term ones) and while the curve hasn’t inverted yet, it has flattened.
Of course, you might think that a recession or full-blown trade war are unlikely. But it is foolish to invest on the basis of a forecast alone. We must consider the distribution of risks. And although the economy looks healthy now, there’s a risk of it turning sick, which would hurt equities a lot. Investors have bought bonds as insurance against this risk.
There’s something else. The structural factors that have caused bond yields to fall throughout this century are still in place. One is the global savings glut. The euro area, China and oil exporting nations are running large external surpluses: that is, their domestic savings far exceed their domestic investments – by $772.9bn (£595bn) this year, according to IMF forecasts.
The counterpart of a savings glut is of course an investment dearth. Which is what we still have. Although the share of capital spending in US GDP has risen sharply since its recessionary trough, it is still below its 30-year average. If overseas surpluses cannot be invested in real productive capital, they must be invested into financial assets. And US Treasuries are a large, liquid and relatively safe home for them.
Yes, the US is running a big and rising fiscal deficit. But in doing so it is giving global investors what they lack – safe(ish) assets. MIT’s Ricardo Caballero has been saying for years that there is a global shortage of such assets – due in part to heightened risk aversion since the financial crisis, which has led to banks and insurance companies wanting more bonds while better quality companies are issuing fewer of them.
Professor Caballero adds something else – that the fall in bond yields since the late 1990s has coincided with stable returns on non-financial US capital. The capital risk premium, he says, has therefore risen. There are several reasons why. The 2009 recession reminds us that the risk of a severe downturn is greater than people thought during the “great moderation”: traumatic economic events can have long-lasting scarring effects on expectations. Or it might be that investors fear that the recent rise in the share of profits in US national income could be reversed. Or it could be that they fear that today’s high profits will be competed away in future by new companies that don’t yet exist.
Whatever the reason, says Professor Caballero, these trends “seem unlikely to reverse any time soon.”
So, what might push yields out of the narrow range they have been in recently? Chris Iggo at Axa Investment Management says a surprise rise in inflation or an easing of trade tensions might raise them, while disappointments about corporate earnings could reduce them. Betting on surprises is, however, he believes “a low-quality strategy”.
Nor is it one we need. The virtue of bonds is that they offer insurance against some nasty possibilities – albeit expensive insurance. They are a way of diversifying risk, not a way of punting on particular views of the future.
