Since the peak of the bond bull market on March 9, 2020, a constant duration 30-year US treasury has delivered a total return of -50% (see the chart overleaf). This is remarkable by any standard, and meets my criterion for a major Ursus magnus bear market. Local currency returns on long-dated government bonds in Germany, France, Italy and the UK are not far behind. What is more, the index of developed world bond market volatility has exploded upwards at a time when yields are rising. This is something we have not seen since 1979-80.
All the bond market panics of recent decades have been buying panics. This is the first selling panic in over a generation.
Now, with prices crashing and volatility spiking, there are certainly trading opportunities in the bond markets, as recent bank earnings have demonstrated. But I have never been especially competent at recommending trading opportunities, so I shall resist the temptation, even though I think that if the stock market were really to crash, the US long bond would rally. Nevertheless, given the magnitude of the slide in bond markets, I am compelled to ask whether developed world bond markets are approaching a point at which longer-term investors might consider buying again. The answer is a resounding no.
To explore why, we must turn again to the work of the great 19th century Swedish economist Knut Wicksell. Wicksell argued that for any economy there are two interest rates that really matter. The first is the market rate, for which the 10-year government bond yield is a reasonable proxy. The second is the natural rate, which equals the long-term growth rate of corporate profits, which in turn must equate to the long-term growth rate of GDP.
In an ideal world, the market rate will be as close as possible to the natural rate. This will encourage stable growth, as there will be no incentive to leverage up and indulge in financial engineering (as when the market rate is too low). Nor will there be an incentive to forgo capital spending in order to pay down debt (as when the market rate is too high). As I have shown before, if the market rate is too low compared to the natural rate, it creates inflation. If it is too high, it leads to deflation-depression.
Now, please take a look at the chart below. The red line is the price at issue of a zero coupon 10-year US treasury, which equates to the market interest rate. The black line shows where the price would be if dictated by the natural rate - the 10-year average nominal growth rate of GDP.
- When the red line was above the black line, long rates were too low. And when long rates were too low, there was generally a rise in inflation (shown by the blue line). The exceptions were either when there was an economic crash or when the price of oil fell out of bed.
- When the red line was below the black line, long rates were too high. This led to a fall in the inflation rate, with oil prices eventually cratering, as in 1986.
- When the red line was closely aligned with the black line, the economy was in what we can call a Wicksellian period. The only companies with access to capital were those whose return on invested capital was higher than the cost of capital, and which therefore had no problem repaying their debts. The results were stable growth with decelerating inflation. The best example was the so-called “great moderation” from 1986 to 2003, initiated by Paul Volcker and continued by Alan Greenspan. This managed to surprise everyone, even though it was the entirely predictable result of following a Wicksellian policy.
Where are we today? For years, the market rate was too low relative to the natural rate. But the increases in inflation we might have expected were forestalled by the 2008-09 financial crisis, then by the 2011-12 euro crisis, and then by the 2014-15 collapse in the price of oil from US$115/bbl to US$28/bbl. Emboldened by the low inflation rate, central bankers decided they could respond to Covid by printing money at unprecedented rates. But unlike previous episodes of printing, this time inflation went through the roof because the supply of goods and services went down while demand went up, together with oil prices.
So, where should interest rates be today in order for inflation to stabilize or fall structurally - a necessary condition if the bull market is to resume? The answer is simple: if the red line falls to converge with the black line (which is relatively stable) then the market rate will be in line with the natural rate. This corresponds to a rise in the 10-year US treasury yield to between 4% and 4.5%. Today, the 10-year US treasury yield is at 2.9%, which means yields will have to rise by at least 100bp more in order to bring the system back into equilibrium. So, I do not expect to cancel my sell recommendation on the US bond market until 10-year US treasury yields reach somewhere around 4.25%. And I don’t expect to issue a buy recommendation until the 10-year yield exceeds 5%. Of course, bond market moves do not happen in isolation, so in my next paper I will look at the impact that these numbers are likely to have on the US stock market. Watch this space.